Despite huge capital inflows, our annual meeting of hotel executives finds market discipline is in place.

How much hotter can the hotel market get? And who will be left standing when the rapid consolidation winds down?

To answer these questions and more, we gathered our annual group of leading hotel executives together during the recent Lodging Conference in Phoenix's Biltmore Hotel. Here is what they had to say during our lively discussion.

NREI: This has been an interesting cycle for the hotel industry, in that people have begun to ask 'when will it all end?' sooner than anyone anticipated. How long does this hotel juggernaut have to run?

Robert Parsons: You have to look at it by segment. I believe that when you look at the building that's going on in the moderate-price segment, particularly without food and beverage, you're getting awfully close to that peak if you're not already there. On the full-service side, in the upper four-star segment you still have a ways to go.

What you'll see first of all is RevPAR growth begin to moderate a little bit. But I think unlike some of the problems we've experienced in 1990 and 1991, what you're going to see here is more of a gradual tapering off of growth, and I think you have a much different capitalized structure out there today where people have put a lot more equity in their projects, financing has been more conservative, so you won't see some of the financial challenges and problems that you saw back in 1990 and 1991. But I think you will see some of the returns that people thought would materialize be less than what they expected.

Dieter Huckestein: If you go back to 1949, we had about 1.4 million rooms total and when you look at the supply coming in today, about 3.4 million rooms, the population growth is equal to 1.3 million. But in between these cycles we have supply and demand, and the dynamics changed as we all know. That's one factor to consider, the population growth is really going along with the supply. No. 2, I think travel is kind of a birthright. No. 3, the international market has increased with a lot more foreign visitors coming here. And the last point I want to make is that the intensity of the travel factor is up. And the income level is there. There are a lots of people coming up from the poverty line, into the middle class and to the point that they want to be able to travel domestically and internationally. There is still room in the supply and demand, but I would agree with you that you have to go by segmentation. We are fortunate that we have a lot of hotels in areas where the cost of entry, the time to get into them is five years. We could talk about Hawaii, where it takes probably 10 years to enter. So from that end, we feel very good about the where we are in the markets going forward.

Parsons: It's interesting that a lot of major hotels now are running what are historically very high occupancies. It's not uncommon now for chains to run 70%, 80% occupancy in some of the quality tiers.

NREI: I think it's 100% in some of the cities that I want to spend nights in. I can't get a room in New York now.

Parsons: New York or Boston, it's very difficult to get rooms. I think it's important that as we make long-term projections though, that we focus on that element. I don't think you can look at a point in time where a chain of 100 hotels has run 80% occupancy for a five- to 10-year period.

The other thing to keep in mind is that this industry has always been supply driven. Demand has been very steady over 25 years. Our expectation is that it will continue to have steady growth in that 2% range, and what we all have to watch is supply. The nice thing is that, particularly in the full-service sector it's pretty easy to monitor supply, it's easy to watch it be built.

NREI: But you're just saying that because you're in full-service hotels.

Parsons: But it's one of the reasons we're in full-service hotels. It's true. You know exactly what supply changes are going to occur by market at least a couple of years in advance. So it gives you a lot of advance notice, unlike some industries where supply can change relatively quickly.

NREI: How does this impact RCI?

John Rhinehart: From the standpoint of the timeshare scenario that is now beginning to play out and have some degree of acceptability within hospitality circles for the first time, clearly I think we're going to see some play across various market segments of timeshares, and I don't think it necessarily will be the same traditional type of product that we've seen for the last 15 years.

Fred Mosser: Back to the original question, have we peaked, I don't really know the answer but I see differences in this growth cycle than the previous ones I've been fortunate to live through and survive. Looking back at the '80s, what is not driving this is a lot of syndication dollars or the residential stuff.

NREI: Funny money?

Mosser: Funny money which was totally irrational. Today, there's more activity going on, certainly in the mid-market and below, but there's real equity in the deals, lenders are still not too bullish, they're cautious and not pushing money out the door. I think there's more market regulation going on in those segments we're in. As long as the economy keeps going at a reasonable clip we're OK.

I'd just like to respond to one other thing, and I agree with Dieter, even if you look at the mid-market segment, which we're now focused on, if you look at the supply and demand of the new-built product versus the older product in that segment, you'll see that supply and demand are equal. The new-built is stealing business away from the older product. New construction is out-performing the old.

Parsons: But at some point doesn't that put competitive pressure then on that whole segment, where older properties need to do something to try to protect their market share?

Mosser: I see them going down the hill rather than up. With the full-service Sheratons, Hiltons and Marriotts in the four-star market, their rates are going up and we're floating up with them rather than being drawn down by the older product.

Paul Novak: I think it's really interesting because I think there's a huge void starting to be created again in the moderate-priced segment. The true competitors in the moderate-price segment now are Hampton and LaQuinta, because they've lifted up from what was really a lower budget product when they started to really right in the middle which is competing directly against the old Holiday Inns, Ramadas, Howard Johnsons and those types of properties, and sucking the business out of that. So there's starting to become the void in there where you've really got product representing the mid-price market that's not really what the mid-price market really needs to stay in. So it's going to be curious to see what happens in that segment in the next few years, particularly as what has been the core of the mid-priced segment starts to physically deteriorate. Much of that stuff is now 25 years old going on 30.

Michael Leven: From a cycle standpoint, you could make the argument today that we are at the top of the cycle in general for the industry on the basis that occupancy has really peaked. We see a little over a one point occupancy decline in the U.S., and is predicted to be more next year. And if we look at the cycle on the basis that it is an occupancy cycle you're looking at, you could say you're at peak or past peak. If you look at profitability as a measure of the cycle, we're probably not at peak yet because we've had enormous rate increases over the last number of years. That rate increase, combined with lower operating costs and more efficiency in buildings, have produced higher levels of profits. But if you look at the business traditionally, these buildings were not built to operate at levels of 80%. Most hotels were built to be profitable at levels of 68% to 72%. And you've had situations where you've had moderately priced product like Bob's Fairfield Inns, a chain running high-70s and pushing rates into the $60s, a product that was originally built to be in the low-$40s.

What's happening is guests are starting to move around on that basis, and new supply comes in and takes pieces of that market and competition for customers will determine who gets a share. But profit is still there because rates decline. So the first indicator of a lack of growth in the profit cycle will be when rate increases begin to dramatically slow from double-digit which we're seeing in these kinds of hotels (waving hand) to single digit and closer to the inflation rate.

Lewis Miller: On the lender side, we see it from both a retail development and hotel development standpoint, the lender and developer suffered from OCD, we were all obsessive compulsive disorder people. You had this incredible desire to put money out. You've got to applaud the Ethan Penners and Bob Blumenthals and the Hellers and Finovas of the world that we kept a cap on the desire to put money out. We still want 1:4 coverage ratios, we will only go to 65% financings. Developers still suffer from OCD, we want to put the bricks up as quickly as possible and it's really the lack of getting debt capital to the levels of where it was in the past. I can't get 80% financing, I can't get 90% financing. I can get mezzanine financing, and that is awfully expensive.

Morris Lasky: It's the old story of 42 years in the business. What everybody kind of forgets is that one room in the market affects the entire market. If an economy hotel room comes on line in the market, then whether it's the economy, mid-range or luxury, that one room impacts the market. It gets taken away from someplace else. So that the more rooms that are built the more impact in a negative sense will happen in the market. I truly believe that it doesn't fall based on the overall, it's based on the market itself. We've never really had a situation where everything went down at one time. It goes down by marketplace and by product.

I'm seeing the same things I've seen cycle after cycle where lenders are now pushing to get out money whether it be on the first-mortgage basis, mezzanine funds, the REITs, etc. There is money pouring into the industry, there are more rooms coming on the market. We have turned around lots of hotels over the years and we're now back into receiverships, early on in the cycle.

So we've seen the front of the wave, and we're beginning to see it weakening. Where we're seeing it is in the economy hotel segment, that's where the receiverships have begun. That's where traditionally for us they've begun. And we know that we're doing a lot more consulting now for lenders that are being a little concerned about properties that they have. So we're seeing the beginning of the next cycle and we think we're very early on. How far will it fall? I can't tell. But we always have suffered from the affects of things we can't control -- the economy, the Gulf war, a whole variety of other issues. So I think we're at the beginning of the next cycle and the down cycle.

Parsons: In general I agree with your observations, but one thing to keep in mind as you look at all of the capital that's out there, a lot of the capital that's come into the market in the last couple of years has been to restructure existing situations, and it's really not new capital coming in for new building.

Look at our company. We've raised $3 to $4 billion in capital in the capital markets in the last three years and not one dollar has gone into the development of one new roof yet. It's all purchasing hotels, it's refinancing existing debt that was in place that's come due. And in all cases those financings have become more conservative, they have better loan-to-value relations. So I think that's a factor to keep in mind as we look at these huge capital inflows.

The big question going forward will be when a lot of the debt restructurings get done and a lot of the acquisitions that were readily available have been acquired. Now the next big stage is going to be as people have to grow, how are they going to grow. I think you're going to continue to see a significant increase in new construction and then I think you're going to flow right back into this cycle.

Jacques Brand: There has been a transition between private ownership of hotels to public ownership. Capitalization of this industry in the early-'90s was closer to $10 billion. Today it's $70 billion and if you take a look at leverage and the access to capital as the driving forces to new development and growth of the industry as a whole, public companies are disciplined by the equity markets. There are more equity lodging analysts covering the market who are more concerned about anything more significant than moderate leverage and today's public companies are leveraged more moderately than they were in the late-'80s and the early-'90s. Many of the projects and major owners and developers of hotels got in trouble were those who sought single-property project financing and were able to get financing through funny money. Today the interest expense as a percentage of revenue is at an all-time low, since 1982. To the extent that public companies begin to take on more and more leverage clearly will be recognized by investors and their concerns will fall out of that.

Lasky: My experience is that we used to manage toward an exit strategy. And none of this looks like it's managed toward an exit strategy because quite frankly a lot of the properties were purchased way above their real value. The answer that I got in terms of the question was that 'we're buying with low-priced money.' But when you finally get that capitalized to the bottom line, that doesn't make any difference. So if paid 10 cents and you can only sell it for eight, some day when there's an exit strategy issue with these properties, the reality is they're not going to get what they have in it.

Parsons: An interesting exercise would be to take all of the public companies that are out there and add up all the stated growth objectives that all of these companies have and look at what would have to happen for everybody to meet their growth objectives. It's just not going to happen.

Miller: If you take the average age of the analyst who's doing the underwriting and you'll find out it's the early-30s and they haven't been through the cycle.

Parsons: Everybody thinks that they have their own niche and their own unique story and a lot of people do. We're better managers, we have the better sites, we have a little niche in the market here or whatever it might be, and I think that a lot of those stories will work. But there will be those that don't.

Lasky: I think the feeding frenzy is over. It's over because you just can only pay so much for these things and I think they've been overpaid. We're going to suffer the results three or four years from now when indeed some of these properties are going to have to be divested and people are just not going to pay what they were paying for them and the loss will occur then. Who's going to suffer? The investor.

Leven: Why do they have to be disposed of? If these properties continue to be profitable for the public companies and profitable means one cent of accretion. I've been very fortunate to be part of a REIT board, a very successful REIT over the last number of years, and my mind has been boggled by watching this company buy properties and buy companies. It's actually a learning experience because I would never in my wildest dreams believe that you can buy properties like this, but every single property that's been bought has done exactly what it was supposed to do or better, and it's a long way down from 18% rate increases to come to a point where these properties fall into a situation where they're no longer 'accretive,' which is the word I learned. So I think that the traditional way you look at things which is probably similar to the way that I look at things is maybe changed because you don't have to get what Dieter has to get for a return in a REIT scenario to be able to make the thing work. It's a different set of numbers.

Michael Goldsmith: I think you see a lot of parallels in multifamily right now in terms of the story that is told for as many multifamily developers inevitably is to either be specialized or have geographic focus. Those that are not of scale and those that are not meeting earnings projections they are targets for acquisition. And there is a massive consolidation going on in the multifamily sector. If the parallel is true, I would suggest that the underperforming operating companies that are C-Corps today will be targets for consolidation. Those that are making promises about profitability and growth and fail to meet those expectations will find themselves targets. There's very little they can do to protect themselves.

Parsons: I think an interesting observation is that REITs historically were set up to be relatively low-growth vehicles paying dividends. I think the reality though for the last couple of years is that lodging REITs have been very high-growth vehicles. Starwood has had huge growth rates and is projected to have high growth rates for the next couple of years. I think Mike's right, the adjustment's going to come when you can't make 30% FFO growth, you're back down to 10% where you're going to be long term anyway. You can create the multiples that REITs are trading at on a 10% growth rate. And you can't sustain a 30% growth rate in these lodging REITs long term.

Leven: But Morris is talking about single-asset sales. But Dieter's company can't compete with a REIT buying an asset because his hurdles are very different from the REITs' hurdles, and that's changed a whole lot of the way you buy properties. It also changes the results you expect to get from those properties.

Parsons: You say those hurdles are different because the fundamental economic hurdles are different or because Dieter also has to deal with the earnings impact of the real estate? Because I would submit that the hurdle rate of a C-Corp. like ourselves is not that much different than the fundamental hurdle rate of a similar lodging REIT.

Leven: But you would not make the investment in a particular asset to get the same return that a REIT would get because a REIT can buy at a 6 or 7 or 8 cap which I have seen.

Parsons: No, we wouldn't buy at a 6, and I'm not sure they can either! Doing that now either they're banking on significant improvement in cashflow which we wouldn't do, which is a risky way to invest, or there will be an adjustment when the reality hits. There will be an adjustment in the cost of the equity and the availability of equity.

Randy Heller: That's their argument isn't it? Their argument is, 'we're trading at a high multiple -- 40 probably in Starwood's case -- and they buy something at a 15 or 20 then that's got to be accretive. Then is that theright economics because it's accretive today? What happens in the long run? Was that a good buy or not? It seems like it shouldn't be any different than the fundamentals we're all used to looking at.

Leven: It shouldn't be except that the REIT will not sell the property. But the stock will go down and the REIT will move its access to capital. The dividend will get cut and the stock will go down some more. And it's not the lender now, it's not going to the RTC, it's grandma in Scottsdale who is out.

Goldsmith: And by then Zell will have picked up 10% of the shares.

Lasky: I have a final question that goes out to the table. I don't understand what's going on with all of the consolidation when they're trading at 40-times multiples and they're still gobbling each other up. Is there really a gain that's happening here or is it just a desire to get bigger?

Parsons: I think one of the things we've all learned is that there are some economies of scale in real estate, whereas 10 years ago probably would have not thought those economies existed. There are economies of scale in multifamily, where they can be more efficient running these huge portfolios, and I think you can see that in hotels. There are some good fundamental business reasons why you might do that, and there are probably some other factors going on today too.

Brand: The spin on that is combining reservation systems, distribution. Let's just take an example, between Doubletree and Promus. One good example is just access to capital and the lowest cost of capital. Promus borrows at Libor plus 32. They're an investment-grade company. Doubletree is unrated and borrows anywhere between Libor plus 150 and 200 over. The combined companies are investment grade and $700 million of debt can enjoy a basis point of more efficient cost of debt capital which will ultimately flow through to the bottomline and through to shareholders. A lot of these mergers are happening because they're REITs such as Starwood which have historically employed a multi-brand strategy and they've now aligned themselves with Westin and will be reflagging and have the ability to raise rates and there are a lot of logical reasons as to why Patriot and Wyndham merged, why Bristol acquires all of Bass PLC's assets, why a Marriott International acquires Renaissance for what seems to be a very aggressive price but allows them a platform to enter 40 new markets and do another brand.

Lasky: My speculation on all of this is the problem that we see in the future will not happen at the property level but will happen on the corporate level, because the corporations are really out of control in terms of how they're buying, how they're consolidating. Properties will continue to be profitable on some level and probably not so far off from where they are now, but at the corporate level they're not going to be able to show the earnings they have to show no matter what the properties do.

Paul, the reason that new full-service hotels are not being built is that we still haven't achieved the level that we can build and operate them economically. You can't build them cheaper than you can buy them.

Novak: You've got to be careful with that. I am not a believer of this justification of the reason you buy is because you bought at a percentage of replacement. It's irrelevant. If you can't support the replacement cost it doesn't necessarily mean that what you paid was a good deal. The replacement cost wasn't a good deal in the first place. (laughter) It still may not be a good deal at 85% of replacement.

Leven: What Morris hasn't seen in some of the cycles is you haven't seen the kind of commentary that you're seeing at this table from people who buy and develop. Because what Paul just said and which I totally and absolutely agree with, and that doesn't mean it's true, although you could add up a few of the comments from Dieter and Robert and Paul, what you hear from the people who are significantly into the buying model, is that there is a discipline. And that discipline has changed some of the nature of the profitability aspect of the business. Yes, some of the REITs or some others may have lost a little of the discipline, but even so this is much more disciplined today than it was in the previous cycle.

Brendan Sullivan: I think from a supply point of view, it will be more regionalized. Many of the markets up in the Northeast are safe for several years into the future. In terms of what's been occurring in the market, specifically in New York, we're getting to the point where assets will begin trading at replacement cost and people will look to build as opposed to buying all their assets, many of the hotels being 40 or 50 years old. So we'll see several new projects within the next few years.

Huckestein: One question I'd like to ask is can you really believe that supply is creating demand?

Greg Spevok: The proliferation of brand segmentation and new construction does not create demand. Outside of very unique markets, such as Las Vegas, demand is created by an expanding GDP and not by the actions of hospitality executives. It is exogenous factors such as corporate profits, a surging stock market, low unemployment, high consumer confidence and an exchange rate that encourages domestic travel that increase demand for hospitality product. The industry will peak when one or more of these demand indices turn unfavorable at the same time that supply increases.

Jacques Brand, Managing Director - BT Securities Corp.; Lewis Miller, CFO - Jacoby Development Resources; Michael Goldsmith, Group President - Heller Financial; Fred Mosser, President & CEO - Wingate Inns LP; Randy Heller, Vice President, Commercial RE - Finova Capital Corp.; Paul Novak, Executive Vice President - Patriot American; Dieter Huckestein, President, Hotel Division - Hilton Hotels Corp.; Robert E. Parsons, Jr., Executive Vice President & CFO - Host Marriott Corp.; Mike Leven, President - US Franchise Systems; John Rhinehart, Executive Vice President - RCI; Morris Lasky, Chairman - Lodging Unlimited Inc.; Greg Spevok, Vice President - Bear Stearns; Brendan Sullivan, President - InterBank/Brener Brokerage.