The U.S. economy has been downright inhospitable to the hospitality industry. Not only have hotel sales plunged to a fraction of last year's deals, but the sector also has been whiplashed by declining occupancy levels and room rates.

In 2008, the volume of annual hotel sales reached $10.7 billion, but by the end of September 2009, sales totaled just $2 billion, according to New York research firm Real Capital Analytics. By comparison, at the peak of transactions in 2007, annual sales totaled a lofty $77.4 billion.

So dire has the financial status of the hospitality industry become as a result of the recession and scarcity of credit, that it has led to an upheaval among the hotel investment giants and a reversal of financial power — at least for now.

Just three years ago, private equity firms were leveraging to the hilt, gobbling up hotels as they awaited returns exceeding 20%, a reward level to which they had become accustomed. Often, they held hotels briefly before flipping them. But now, with credit in short supply and loans coming due, many private equity firms are in no position to buy.

“There's a lot of vulture funds, and private equity guys that haven't been buying anything recently. They're pulling together a lot of money trying to buy distressed assets. But they've got a tremendous hurdle,” says Gregory Rumpel, executive vice president for Jones Lang LaSalle Hotels. The hurdle is that vulture funds, private equity funds that target distressed assets, still demand returns over 20%.

Enter the real estate investment trusts (REITs) specializing in hotels. They're ramping up to buy in 2010 with cash straight from their balance sheets, says Rumpel. In their favor, hospitality REITs set their sights on more modest goals than the vulture funds. Many are content with annual returns of 6% to 8%.

“The REITs gear up to deliver consistent returns, whereas private equity is looking at buying in, turning assets around and then getting these huge pops in value when they exit or refinance,” notes Rumpel.

Hotels lead in delinquencies

The hospitality industry malaise isn't restricted to any single type of investor. Too many companies gorged on properties from 2006 to 2008 and are suffering indigestion. Many deals were financed through commercial mortgage-backed securities (CMBS), and that's a problem.

In September, the hotel sector recorded the largest proportion of all CMBS delinquencies, at 5.8%, reports New York-based Fitch Ratings. By comparison, delinquency rates in the office sector reached just 1.9%. In line with the rise in hotel defaults, Fitch projects that hotel property values will fall by as much as 50% from peak levels, according to a statement by managing director Susan Merrick.

Delinquent hotel loans totaled $1.1 billion in September, Fitch says. Defaults included a $587 million note for Extended Stay America, which filed for Chapter 11 bankruptcy protection in June, and a $207 million loan for Resorts International, based in Atlantic City, N.J.

“I don't think [delinquencies] are a terrible surprise to anyone,” says Jeff Higley, spokesman for Smith Travel Research, based in Hendersonville, Tenn. “What is surprising is that there hasn't been this onslaught of distressed properties that have come on the market to buy.”

Part of the reason is the difficulty in determining valuation, he says. Banks that have taken back properties won't give them away at fire-sale prices. Some buyers want to pay 30% of value and get a 70% discount, says Higley.

“So we're in a no-man's land in the hotel industry right now, just waiting for the valuation process to make its appearance.”

Economy batters fundamentals

In the meantime, revenue per available room (RevPAR) is projected to drop 17% this year from 2008 levels. For 2010, the forecast is still negative, though improved. RevPAR is expected to decline by 4%.

“All indications are this is not going to be a very pretty winter,” says Higley. One encouraging sign, however, is the healthier occupancy at hotels along interstate highways.

By the second quarter of 2010, the days of 20% weekly RevPAR declines could give way to flat growth or a slight rise as travel increases, he says. “Optimism could start coming as we get year-over-year comps that are a little less dramatic and a little less of a slap in the face to the industry.“