Editor's note: Will it last? That is the most-often asked question these days about the hotel industry. Year over year record profitability over the past two years has led Many a market watcher to ponder the future course of hoteling, as the subjects of brand proliferation and internal operating efficiencies dominate conference discussions.
Recently National Real Estate Investor gathered a group of the hotel industry's leaders for a discussion of the issues most impacting them and their futures. The discussion was held at The Arizona Biltmore Hotel in Phoenix during the successful Lodging Conference '96.
Q: I suppose everybody here knows better than anyone how profitable the hospitality industry has been in recent years. But still, there are a great many questions today concerning the potential for overbuilding. Is that a major problem and is there room for optimism?
Greg Spevok: We think that for the industry, RevPAR peaked early this year. And it may not be prudent to be buying hotels at the numbers we've seen lately. I still think it's very hard to get construction financing. You see a few full-service hotels being built, but these are very specific niche markets. For budget properties I think it is much, much,easier now to find financing locally. You also have an obsolescence factor among existing properties.
Dieter Huckestein: Let's start with the overbuilding. I think by segmentation the demand factor is strong, supply is sufficient. I do believe the international market is going to get stronger and stronger. The Asian market is strong with economies still growing at 6, 7, 8%. The RevPAR has peaked. You have to be careful and selective. What's interesting to see as a trend is single and double rates. For 8 years we weren't able to do it. We gave it all up. Now we talk about late check-out charges. It's not necessarily an increase in the rates by 10% or 5%, it's really going into the yield management. I think yield management will drive RevPAR in hotels.
Financing is still very hard to get. We find that we have some prospects, being very, very selective where it makes sense, to build a full-service hotel. But as you know our strategy is to buy full-service hotels in key areas, and hopefully buy them below replacement cost. Financing is available for our mid-scale market. With our Hilton Garden Inn, we are doing quite well with over 100 hotels with financing in place. So there seems to be a demand factor to build in the upper mid-scale hotel product now.
Q: And to take advantage of your brand name.
Huckestein: For us, we have an opportunity by default in a sense that we are not represented in many places. When you look at a lot of areas, particularly the tertiary markets, coming in with a new product with a very strong brand we believe that we have a great opportunity in building the product.
Ravi Patel: Certain segments are overbuilt. Most of the building took place in the last few years in the economy lodging properties and suite and extended-stay. There's no building at all in the full-service industry. We see overbuilding, on the budget side, but it's not just overbuilding. The supply is increasing because what happened is it doesn't make any sense to put $5,000 to $10,000 per room to recondition. The owners of older properties are moving from full-service to budget, so the budget segment is increasing. if you look at Randy Smith's number (of Smith Travel Research) there supply and demand is not balanced. There is more supply.
The glut is going to come in full-service. The Hilton Garden, the Courtyard by Marriott, you'll see a bigger glut to market the middle project hotel. Hampton isn't considered any more economy lodging property. The last two years, they've jumped their RevPAR growth by 25%. Only certain developers will get financing from the local bank. A few years ago it used to be SBA financing only to build 50-60 rooms. Now I see quite a few developers who could get a project going, with good track records, they are developing $4 to $8 million projects. We are developing right now two Courtyards and two Fairfields at a cost of $4 to $6 million, and local financing is available. I've seen quite a few developers refinancing with Wall Street. So they are able to get good terms and cash out. We will refinance after two, three, four years and go back to the local bank.
Thomas Hewitt: From a macro standpoint when I look at our industry I'm very bullish, basically across the board. I,m very positive. Certainly there will be some pockets if you will from a geographical area and from a product segmentation that will be squeezed a little bit, but overall I think we're in pretty good shape and I think we're going to continue to be in a positive trend for three to four years.
I think one of the most important things to consider when you're looking at the health of our industry is how well we learned our lessons from several years ago. We all know that the entire capital structure of our industry changed over the last eight or 10 years. New owners are in here, leverage is totally different, totally new groups of investors are in here, the REITs, the funds, Wall Street. This augers well for that inevitable downturn. I happen to think the downturn is going to be much better managed. It won't be, when it does come, as deep. And the key is that we're far better prepared to handle it. Our margins, because of debt service and greater efficiencies and better branding and all the other good things that we've learned over the last five or six years have prepared us, so that our margins may shrink but we're not going to cross that line.
As far as the full-service and budget and what-not, we're out in the marketplace, we're very aggressive trying to acquire properties as is everybody it seems in the country. We've been very successful over the last year to year and a half. Hopefully that will continue. We see now where acquisition prices are pushing $0.80 to $0.85 of replacement cost, whereas three years ago it was $0.40 to $0.45 and two years ago it was $0.50 to $0.55. I think we'll get through 1997, but by the end of 1997, there are going to be very few quality properties that you are going to be able to secure at a significant or even any meaningful discount to replacement and of course that's going to trigger what you'd expect in the full-service area anyway, and that is some development. I'm hoping that it will be well thought-out, well-planned, well-disciplined development. And we're going to be OK.
Randy Heller: I'm probably pretty much in Tom's court, although I don't think I'm quite as bullish. Whatever that number the industry's going to make this year, whether it's $8 billion, $9 billion or $10 billion, coming from a loss of $5 billion or $6 billion just five years ago, I think we're pretty much at the top. I don't see a precipitous fall-off in the industry for a couple of years. I don't know if it will top this year, or if maybe we're already there as some of the others have suggested. I don't think it gets much better from here. It will go down, but I agree with Tom that it won't go down as precipitously as we've seen in the past. We don't have tax incentives that drove it up. There aren't things typically being built except for `economic reasons' or perceived economic reasons. Not everybody's always right, but there won't be tax motivations, at least not that we know of today. I think you have better capital structures, more equity inand even when construction money comes back like it has in the limited-service, I don't see it coming back as crazy money like it did. So I think there are a number of protective things that will help us on the downside as we get to the end of this century and I don't think we'll fall off nearly as bad as we did in the past.
I think there are opportunities in every segment now. We have always looked at the world as we were making loans in the early-'90s that there are good deals in bad markets and bad deals in good markets. You just hang in there and deal with the right people and find the right transactions. I get a little scared about segmentation, personally. At some point you only need so many rooms in a market. I don't care if they're limited-service or extended-stay. So at some point those markets overlap, and I think we saw it in the retail business with the big-box concept. So I get a little concerned about the number of brands and the segments, but other than that I look for a couple of more pretty good years, in terms of capital being available and in terms of profitability of the industry and growth.
Q: Someone's going to have to come up with another cute buzz-phrase like `Stay alive until '95.'
Heller: How about `It'll be fine until 1999?'
Kirk Kinsell: I'll just add two comments. While I think our capital markets have given us a lot more hope for being able to survive a downturn, a lot of these public monies are public monies and they're looking and measuring returns on a quarterly basis and we've set some pretty high expectations. I think I was here last year saying we need to be aware that next year's RevPAR improvements are not going to be anything near what this year was, and this year was a great year.
I think we're going to need to be better operators. I think we're going to need to look more at some of the other cost structures that haven't been attacked in our hotels, primarily those cost structures which articulate as being acquisition costs. We spend a lot of money as an industry bringing a customer to our door and yet all they do is stay in our guestrooms, but then they go out and they go to someone else's restaurant and someone else's gift shop and someone else's retail. I think we need to refrain that and think more about revenue per customer and be a better operator in terms of our food and beverage experience, our retail experience and all those other things. That brings a framework of more entertaining the client as opposed to just housing them in a clean room.
Q: So you're talking about a one-stop shopping concept?
Kinsell: Yes, and I think that speaks very loudly in terms of our long-term relationship with the customer. When they leave your property, we spend so much to acquire them that we still want to be in their minds when they're staying at home. That's what frequency programs are supposed to do. So there are other ways to capture that.
Robert Parsons: We are still very optimistic about the industry and about the market. We're optimistic both from an operating standpoint as well as from an acquisition standpoint. Although clearly the acquisition market is becoming much more competitive over the last 12 months. On the full-service side, which is where we really focus, maybe unlike the more moderate-priced or economy, we just don't see any real construction going on right now. We track the top 35 markets in the country with both construction starts and planned projects as well as stuff that's under construction. If you back out Orlando and Las Vegas, which are both very unique markets, we believe there is well under 1 1/2% supply growth in the full-service segment. On the demand side, we think it's going to be close to double that, so clearly you have a very good set of underlying fundamentals, the way we look at it.
There's a lot of discussion about new construction, but there's not a lot of new activity yet. Now having said that, we would expect that in 1997 you would see a number of projects become committed to by various parties and as we all know it takes a couple of years to develop those projects, so we think that for the next few years we're in a real good situation from the supply standpoint, but that new construction will start. We believe that for well-capitalized companies with good operators either tied into those companies or because they are the same company, that you can get financing for projects now as long as you're willing to put a substantial amount of equity into the transaction, and I think you'll see some of that happen next year. And I think that's an area that you'll even start to see us focus on a little bit, because we're going to be making some commitments to some development projects.
On the acquisition front, it's clearly a lot more competitive, but what we've found interesting is the multiples that we are buying our assets on this year are identical to what we paid last year and the year before on an EBITDA or a cashflow multiple basis. On a percentage of replacement cost, clearly that's moving up and we're paying about 75% of replacement cost this year, which is up about 5 percentage points a year over each of the last couple of years. But because cashflows have also gone up, we have found that our multiples have pretty much held constant. We think next year will be more challenging. Everybody is out there in this market. But I think what we have to all do is find unique opportunities where we maybe have some competitive advantages in that area, where we maybe have some unique links or relationships that we can play off of to continue to acquire hotels.
We think there will be a lot of hotels that trade hands. There are just a lot more players out there right now.
Morris Lasky: The one thing that everybody seems to forget, after 40 years in the business, I still believe in seven-year cycles. The thing that most people forget about is the largest problem in the hospitality industry is amateur hour. A lot of people that own hotels, even franchise hotels, don't have the management skills. It shows up in the lack of average rate, in the lack of using reserves for replacement other than distribution to investors so that they're not keeping properties up, `in spite of the franchise relationship.' So somehow nobody ever notices what I consider the biggest problem. We've done about $3.5 billion worth of turnarounds, and most of that was for owners that didn't have experience, that built 100- to 500-room hotels and then tried to manage it themselves, and for some reason the lenders allowed them to do that and still are allowing them to do that. We've gotten very involved in lender documents and find out lenders really don't have teeth in their documents to go after operators who are not doing the job keeping the properties up, marketing the hotels like they should.
I think the biggest problem in the industry aside from amateur hour is the lenders that are not paying attention to their own portfolios and they look at them once every year, maybe, and most of the time the investment loan officer really doesn't know what they're looking at. So by the time the issue becomes a real issue, which means they haven't paid debt service for six months, then the lender really begins to realize there's a problem and that's when the hotel hasn't been kept up for a year and a half or two years, that competition has overrun the property and all of the inherent problems with that.
So I think the problem No. 1 begins with the lending institutions. They want to put out dollars. They've been putting them out inappropriately on properties that may or may not be proper at the time their feasibilities are done. But the basic question that lenders don't ask is who's going to manage the hotel and what guarantee do we have that that management is going to be in place over a period of time, and what control does the lender really have over that particular activity. And I can tell you from a lot of experience, none.
And by the way, bad, because it hasn't changed a bit because in the early part of every cycle the same thing happens with us. We begin to see litigation support, lenders suing owners, owners suing lenders, and on and on. We're seeing a lot of bankruptcy issues this early. We've been called in the last few weeks on as many as three or four possible receiverships. The entrance into that issue is the lenders call us to go in and do an intense study to find out what's wrong. But it's already so wrong at that point that they should have called that shot a year ago.
So if you go back to the basics, if the lender had really built the proper safeguards into the loan, a lot of this wouldn't happen. My main concern is operators who really don't know what they're doing, who don't have the skills. What's outside this room is where the real problem is and there is a large number of hotels out there that even in good markets don't make money.
Q: So it's operations, operations, operations?
Lasky: And lenders wake up.
Q: I noticed that there seem to be a lot of legal professionals here in attendance at your conference. Why is that?
Lasky: Because a lot of things that are going on in the industry are leading the attorneys to believe that there is a major amount of work to be done. I'm talking about litigation. They're seeing that we may be on the verge of litigation all over the place. I don't think it's deal making or building new hotels.
Kinsell: I think they're just here looking for work. Most of them are bankruptcy and most of them are development people. I think you're right, the work that's coming is litigation. I'm not sure how soon it is.
Lasky: A lot of owners who are disgruntled and unhappy with management companies and franchise companies are going after them.
Parsons: But isn't that really relating to transactions that were entered into some time ago?
Lasky: The answer is yes.
Parsons: There's been a huge change in the structure and content of management contracts in the last couple of years, all moving toward the benefit of the owner.
Kinsell: Your point is well taken on the lender side. When we enter into comfort letters which are issued to lenders, when you sit down with that lender and you say you want to have a relationship that is unique to what our prior relationships have been, we want to be working together, and then all of a sudden the lender doesn't want to accept the responsibility that they really should be taking. They want to put it all back on the franchiser, which is unreasonable, because the only stake we have in this game is some percentage of the gross. We don't have a lot of leverage sometimes so we're looking for somebody to provide that leverage to keep those hotels which are branded with our good name in good condition.
Parsons: Most of the capital that has come into our industry has been to refinance existing debt, and in most cases recapitalize that debt under a more conservative capital structure. So I think that from a financial standpoint there is a lot of equity that's going to be lost before lenders are going to lose money overall like they did a few years ago.
Lasky: I'm not so much concerned about the lenders losing money as the fact that equity will be lost and property owners will lose properties. Every time there is a foreclosure in any area of the country, there's a blight on the hotel industry right there and it really doesn't help us a bit. We really wish the lenders would get smarter because we think it would help the whole industry. And they can be smart with their early-warning system.
Patel: Also they are putting in clauses now to maintain 1.25 coverage. That is smart.
Lasky: The problem is I can give you that 1.25 and stop spending on maintenance, marketing and reserve replacement, and eventually the whole thing falls on top of itself.
Heller: You have to start with the covenants. Our loans are fairly heavy in terms of covenants, in terms of replacement reserves that go into an actual account that we have a lien on and cashflow coverage covenants, periodic site inspections of the properties. But when it comes right down to it, if you're not dealing with the right people it doesn't matter. They'll produce you the coverage somehow.
Parsons: On the positive side, with all of the securitization going on, most securitized loans in general have a little bit tighter covenants, cashflow controls, controls over FF&E, and as the industry moves a little bit more in that direction that should help to strengthen some of the financing documents that are out there.
Brian Maier: We certainly share the view about full-service from an equity research standpoint. I also take comfort from the fact that the few full-service hotels that are getting built, in places like Miami, these were not simple things to put together.
The truth is, we as fundamentally real estate people are believers in barriers to entry, so we feel good about it structurally longer than two or three years. And in fact, we have recently gotten very active on the lending side, which is a relatively new area for us as an investment bank. Over the last month we've committed $500 million and every penny of it is for full-service hotels and there is another 500 million behind that. I don't think we are comfortable at all in providing fringe financing or securitization. It would have to be a well-structured deal but where we would do bridge loans or provide interim capital I don't think we would do that and put our balance sheet at risk. We're kind of putting our money where our mouth is as well as our equity research and feel good about that sector. And feel good about the operators that are driving that sector. They're well-capitalized, quality companies that know what they're doing and have been through cycles.
We have a Goldman Sachs Lodging Index that has 15 hotel companies in it, and 12 of them didn't exist prior to 1994. ITT is a different company than it was before the spin-off. Marriott is a split company. There's never been a time though where there have been 15 well-capitalized public companies in existence that have gone through a cycle. I'm also a believer that cycles are going to repeat themselves. But we've never had this before. We've never had a period where you had companies with great access to capital of all types, that may be in a position to weather the storm and in fact get stronger by taking advantages of opportunities from some of the weaker players. That dynamic is a question-mark. You can draw a scenario that will make it better or you can draw a scenario that will make it worse. But for sure it's different. There have never been this many pure-play hotel companies.
On the negative side, we are seeing a lot of capital. This whole idea of brand proliferation we find relatively scary. You talk about extended-stay and some of these areas that equate to factory outlets. There was a craze in the REIT industry where the factory-outlet people put up these charts to show the cost of rent per sales dollar and how small it was relative to the department stores and then they talked about the percentage of factory outlets as a percentage of the total square footage and how small it was and you could have mammoth growth. Then all of these REITs were formed to create millions of square feet in a year. Most of them floundered, and a couple of them were merged. The truth is there just wasn't the demand that people said there was, even though you could make a good analysis.
We're concerned that there is a lot of capital availability and there is no way in the world that all of these brands and brand extensions are going to make it. The question is, is the discipline going to be there for all of those different brands that are able to get capital. I have absolutely nothing against Wayne Huizenga and his Extended Stay America, but the level of expectation that is in the multiple for that stock is extraordinary, and there certainly is no room to disappoint.
The other thing that I believe, it is very, very hard to create a brand. There are a lot of people who talk about it, but there are actually very few brands. Fortune magazine does the best-managed companies every year, and this is the first year they even put hotels in it. The theme was that brands rule. So it really is quite difficult to create a successful brand that is sustainable. There is no way all of these can work. The market just doesn't need that many.
Q: At this conference we've heard industry experts tell us about both sides of the coin, that there is no overbuilding problem, and the other side that says there are far too many brands to succeed. Who's right and who's wrong?
Lasky: I'm old enough to remember Kemmons Wilson (founder of Holiday Inn) saying when he was building the first Holiday Inns that they were going to last for 20 years and that they'd be torn down and new hotels would be built on those sites. Guess what? Forty years later the same Holiday Inns are still there and they are still part of the product market. In spite of what everybody thinks, the older properties do not come out of the room supply. They still are a factor in the room supply, whether renovated or not. They are not going to be torn down. The theory that these new rooms are replacing the old ones just hasn't happened.
Spevok: That proliferation you're seeing in most of the new brands is in the economy segment and they are the first to go when the economy turns. The stock market has been up, the economy has been flush and corporations have been flush and spending money on travel. But if the GDP turns a little bit that's going to have an immediate effect on the bottom line. Related to that, hotels have done a very good job on the expense side in the last few years, and hotels are a lot more efficient than they have been. So if the economy turns, there isn't a lot of tightening that can be done on the expense side. They already did that.
Parsons: I think some segmentation is good, but like Brian, I think we have to be very careful. If you want to have an interesting experiment, take some people that you work with and choose a competitor and go through and see if you really understand the difference in all of the brands that competitor has. My experience in doing this is that it's difficult even for us who live and breath every day in this industry to really explain the differences in some of these brands. The extended-stay area is just amazing. Three or four years ago there was one, basically, maybe two players in that segment. Today there are over 10. If you add up all of the growth expectations for all of those companies and the moderate-price segment and take all of the IPOs that were done over the last two years and add up the growth expectations that are built into those companies, it's kind of scary.
Huckestein: The mid-scale market is where it's going to be competitive. We can't afford to make any mistakes. Innovation is critical. From the customer point of view, you have to really follow the customer from the check-in. And technology will be a major factor. And the larger companies with good balance sheets and access to the capital markets will compete successfully. In the marketing respect, the brand equity you get through programs with frequent flyers is something we believe in. That's one of the reasons we are going to Hilton International, having a brand throughout the world. Being a global company, it's critical to us that we put our resources behind that and it will make a difference in this competitive field.
Kinsell: The strength has got to be in how you acquire customers. The companies that are putting the investment in technology are driving GDS systems, your relationship with your travel agents, your Internet opportunities. However, all of those attributes that make it easier for someone to buy your product including the frequency programs I think are where we're going to make a difference in terms of how we're going to be able to survive against our competitors. More and more it's looking at the acquisition costs as well as the acquisition methods of those customers.
Q: How big a factor will consolidation be in the future?
Huckestein: I think in the next five to 10 years you're going to see maybe eight to 10 big players around the world.
Hewitt: I think you'll have two tiers. I do think you'll see a second set of very large companies who have taken advantage of consolidation.
Kinsell: That doesn't mean that you're only going to have eight brands I don't believe. You're still going to have maybe 20 brands, and maybe more because those companies will then be forced to try to figure out how to continue to grow.
Parsons: We agree that consolidation is going to play an important role. But the other thing that's interesting is that besides the consolidation that you're seeing on the operating side, look at the strategic alliances that have been set up between the new kind of ownership companies, a lot of the REITs that are out there, and the various operating companies. There are about 10 new strategic alliances. Almost everybody is trying to tie in with somebody else. I think you'll continue to see that happen too.
Huckestein: You'll see more risk and reward types of joint ventures in the future also. We're seeking strategic partners because we can't do it all. We cannot be as cost effective.
Q: Is globalization a big issue?
Huckestein: If you want to be around in the year 2000 and beyond that you have to have that kind of horizon.
Patel: The world is getting smaller and smaller, you know.
Maier: If you think of the truly international companies, with properties in more than five countries, there are actually very, very few. There's a long way to go toward that.
Parsons: It is a high priority for Marriott. It's something that's hard to do. It takes time and money. Ten years ago Marriott had just a handful of hotels overseas. Today I think they have something like 60 hotels in 35 different countries. But it's taken a big investment in time and capital and it requires you to hire people and staff offices all around the world. But I think you have to do it. All of the major hotel operators are convinced that being a global company is going to be critical over the next decade.
Maier: I think it's very tough. It takes long-term patience, capital, flexibility and a lot of tenacity.
Heller: I think that's where your strategic alliances come in again. When you go to a land where you don't understand how to get things done, you can maybe partner up with somebody that you trust who knows their way around that part of the country.