Hotels are hot: business and leisure travelers are streaming back to hotels and resorts, propelling a healthy lodging industry recovery after a painful three-year slump. Major chains are beating their own forecasts for second-quarter 2004 earnings. Profitability, investors and lenders are all back. But will it last?

"THERE IS STILL A LOT OF HESITANCY IN BUSINESS AND LEISURE MARKETS [blame 9/11, SARS and jitters over terrorism], but it has certainly eased, with a strong uptick in central business districts of main cities, [and with] business travel and the economy on a rebound," says Jan Freitag, director, Smith Travel Research Inc., Hendersonville, Tennessee. Freitag shared these views on the lodging sector in an interview with Mortgage Banking. [??] For the first five months of this year, revenue per available room (RevPAR)--which, together with average daily rates (ADRs), add up to the lodging industry's measurement of profitability--was up by 8.2 percent over the same period last year. [??] Occupancy rates were 3.5 percent higher, and ADR rose to $86.55 during that period. It is the best showing for the industry since 1998, Freitag says. (The terrorist attacks of Sept. 11, 2001, dealt a serious blow to an industry already struggling with dwindling occupancy rates.) [??] Which hotel markets seemed to be recovering most vigorously over those five months? Freitag says RevPAR was up by "an incredible" 22 percent in New York City; by 16.5 percent in Miami; 16 percent in Orlando, Florida; 15.6 percent in Washington, D.C.; and 14 percent in Los Angeles. [??] "People are coming back for both leisure and business destinations," he says. By the end of this year, Freitag forecasts RevPAR will have increased about 5 percent across the United States, compared with a dismal 0.5 percent last year and a steep drop of -2.6 percent in 2002.

Given restrained corporate travel budgets over the past few years, it was surprising to hear Freitag name the Four Seasons, Ritz-Carlton, Starwood luxury collection, St. Regis and W Hotels luxury chains as the ones making stellar come-backs over the first five months of this year. Their collective RevPAR was up around 12 percent--mainly because of increased occupancy--which was about triple the increase for economy-hotel properties, he says.

In early August, for example, Toronto-based Four Seasons Hotels Inc. reported RevPAR was up by 23 percent and overall sales increased by 20 percent during the second quarter this year, compared with lackluster results that had already set in well before a similar period last year. Four Seasons Hotels manages 63 upscale properties in 29 countries.

The outlook for the lodging industry is cheery from another perspective--mergers and acquisitions, investment and financial performance are all up as well. Consider this:

* In April 2004, CNL Hospitality Properties Inc., Orlando, Florida, completed the acquisition of six luxury destination resorts from KSL Recreation Corporation, La Quinta, California, for $1.4 billion in cash and assumption of KSL's long-term debt of $794 million. CNL invested $1.27 billion acquiring 15 hotels in 2002.

* In July, Strategic Hotel Capital Inc., Chicago, announced it is acquiring the Ritz-Carlton Half Moon Bay resort near San Francisco for $124.4 million. It spun off 14 of its 21 hotels into a real estate investment trust (REIT) in June.

* For the six months ended June 30, 2004, FelCor Lodging Trust Inc., Irving, Texas, a hotel REIT, reported consecutive months of RevPAR increases and the first quarterly ADR growth in three years.

And it is likely to continue. In late August, Jones Lang LaSalle Hotels, Chicago, reported that transaction volume doubled to $7.3 billion (specifically 58 hotel properties, each selling for more than $10 million) during the first half of 2004, compared with the same period in 2003. Melinda McKay, the firm's senior vice president, predicts transaction activity will nudge $10 billion by the end of this year--compared with $6.7 billion last year, and almost three times the volume in 2002.

This high volume of activity is attributed to the number and types of buyers, the amount of equity chasing hotels, availability of favorable debt and owners' enthusiasm for orderly disposal of their properties.

As Joe Green, president of Winston Hotels Inc., Raleigh, North Carolina, put it in an interview with Mortgage Banking, "Access to financing began to pick up during the fourth quarter of last year and has steadily improved since. Rates have improved and there is more capital in the marketplace, compared to three years ago, when the ability to find favorable financing was significantly diminished," he says.

Winston Hotels is a hospitality REIT, specializing in "subordinate financing and developing, acquiring and repositioning premium limited-service, upscale extended-stay and full-service hotels in 16 states."

Most Winston Hotels loans are for three-year terms, with one- or two-year extensions, and on the senior side of the mezzanine debt side. "We lend $1 million to $15 million for a single asset, typically on hotels with 100 to 450 rooms, worth $5 million to $75 million," Green says.

No frenzy to develop

If there is excess room capacity (except for some niche and submarkets that haven't been overbuilt), why would developers be building hotels and approaching lenders for financing?

"It's the nature of developers to be very optimistic. I've never met a pessimistic developer," says Green. Nonetheless, there is "no frenzy to develop" and no overbuilding the way there was a few years ago, he says.

It's probably a good thing there isn't evidence of development frenzy. In early June, Reuters quoted New York-based Loews Hotels Chairman Jonathan Tisch's caution that "With rising costs in health benefits, insurance and energy [in the hotel sector], we have to be diligent in how we absorb those expenses and increase profitability. It'll be six months to a year before we get a sense of where oil prices will settle [they've been setting progressively higher record levels since he was quoted], and if the supply of oil will remain such that the consumer can still fill his car to travel."

Tisch figures a full-fledged U.S. hotel recovery won't take hold until mid-2005.

Reuters also quoted Larry Shupnick, senior vice president, development and acquisitions, MeriStar Hospitality Corporation, Arlington, Virginia: "I don't think we'll ever get back to 2000 levels [the strongest year in U.S. travel industry history]," he said. "The turnaround in the hotel industry is moving along slowly, and business travelers, in particular, are dragging their feet"

Not everyone would agree. Michael Fishbin, national director for Ernst & Young LLP's hospitality advisory services, New York, for example, noted in the company's 2004 National Lodging Report, issued in July, that "Business travel is supporting a slow recovery of the nation's lodging industry," moreover "There is increasing activity on both coasts, particularly in the luxury markets."

While the forecast for increased RevPAR this year looks promising, it's still not back to where it was four years ago. Bjorg Hanson, head of PricewaterhouseCoopers LLP's (PwC's) global hospitality and leisure practice office in New York, told Mortgage Banking.

Hanson attributes about 70 percent of the current lodging demand to a recovering economy, although it hasn't reached the point where RevPAR and occupancy levels are where they should be, and in fact are only doing about half as well as could have been expected. He forecasts a 4.5 percent RevPAR increase in 2005, which he says is not "a bad number," but figures it won't be back to 1999 levels until the fourth quarter next year.

And what about new hotel-room supply? Hanson foresees a modest increase this year of 1.2 percent, compared with last year, and rising to about 1.5 percent more rooms next year. "The number of starts of new hotel rooms [across the United States] this year is in the 60,000 range, compared to the 35-year average of 95,000 room a year," says Hanson.

Patrick Ford, president, Lodging Econometrics (LE), Portsmouth, New Hampshire, commented on the supply in a July report: "Capital availability is pretty good, and the lending environment is pretty competitive. [Developers] are getting better terms and everybody wants to lend because lodging is a hot segment." The report also noted that between April and June there were 282 new project announcements totaling 35,604 rooms, which is somewhat more optimistic than Hanson's outlook.

Ford also foresees the development of full-service hotels (with on-site restaurants, 24-hour business centers, fitness facilities and room service) built to house conventions, but for the time being he sees them being built in the 250- to 400-room category rather than the 1,000-rooms-or-more category. He also sees development of other smaller hotels in the suburbs and on highways. LE notes that investors are behind new hotel construction in the pipeline for the first time in four years.

Earning spread over capital

Youguo Liang, managing director, Prudential Real Estate Investors, Parsippany, New Jersey, noted in an August market outlook report: "Hotels have become quite popular among lenders again, partly because hotels typically lead other sectors in a recovery and partly because it is one of the few remaining sectors where lenders can still earn some spread over their cost of capital."

This is especially true in Manhattan. Cheryl Boyer, a director of PwC's hospitality and leisure practice in New York, reported in July that "Investor interest is very high, particularly in New York. There has not been a significant amount of good-quality assets on the market, and fundamentals are very good right now," she explained.

Boyer noted the sale of the Paramount Hotel in Times Square to Lifestar Hotels LLC, a joint venture of Hard Rock Cafe International, London, and Sol Melia SA, Palma de Majorca, Spain, for $126.5 million, among others.

PwC estimates there will be four to seven hotel company initial public offerings (IPOs) this year, compared with 12 in 1996, as well as five to 10 major mergers or acquisitions before 2004 is over (there were 11 major transactions in 1999).

Waiting for the right signs

"Companies have been deferring transactions, waiting for the equity markets to be more receptive, while the equity markets and institutional investors have been awaiting signs of accelerating industry performance," Hanson says.

"The issue hasn't been as much lenders not lending, but equity investors not putting the equity in. For a hotel to be financed, including bridge financing, 30 percent to 35 percent of the project cost has to be available in equity," Hanson says.

Are hotels with a few floors of condos becoming much of a factor? Hanson says there are only about 45 of them in the United States, although about 40 percent of the upscale hotels being planned have a condominium component, he says. "It will be interesting two or three years from now to see how many of the projects that were supposed to have condos or other forms of residential units actually have them," he says.

Hanson speculates there could be a "very substantial attrition rate" in the number of condo-hotel hybrids coming on the market, because the high risk might easily outweigh the potential high returns. However, there haven't been any failures in the hotel-condo category so far, and they have ranged from successful to very successful, he added.

In June, Scott Smith, vice president, PKF Consulting, Philadelphia, reported that many investors "are anxious to redeploy capital" and that many hotel owners are "more motivated to dispose of underperforming assets and appear willing to meet buyer expectations." Investors continue to favor full-service hotels over midprice, economy or budget product, because they see more of an upside to increased profits in that category, he says.

Potential buyers are motivated as well, Smith says, because "interest rates are still at an all-time low, so the cost of financing continues to decrease." Investor yields should continue to improve significantly this year and next, he adds, as market fundamentals continue to improve.

RELATED ARTICLE: LOANS FLOW, BUT CAUTIOUSLY

WHILE LENDERS OVER THE PAST 18 months have become more comfortable and forthcoming in hotel transactions, their underwriting departments are also more cautious, said Lisa Pendergast, managing director of CMBS (commercial mortgage-backed securities) strategies for RBS Greenwich Capital Markets Inc., Greenwich, Connecticut, in a recent interview with Mortgage Banking.

"Underwriters are being cautious with these transactions," Pendergast says, "because they look at the most recent worst case, probably in 2002, and take that into account. Hotel deals have therefore become very well-scrubbed, which also means investors are becoming more comfortable with the hotel sector.

"Loans underwritten today [by insurance companies, real estate invesment trusts (REITs), pension funds and banks] on somewhat downtrodden revenue-per-available-room (RevPAR) properties will be better loans because the credit fundamentals supporting the asset will improve over time," Pendergast says.

There will be more property transactions and, notwithstanding a cautious market, some attractively priced hotel transactions, and more loans and fixed-rate CMBS conduit fusion deals, Pendergast says. (CMBS transactions revolve around collateral typically based on multifamily, office, retail, warehouse and hotel properties. Fusion deals combine a pool of a few hundred loans averaging $2 million to $3 million, with larger loans up to $40 million, usually for single, trophy-type assets of much higher quality to balance the risk.)

Lack of investor confidence in recent years reduced the number of hotel loans that flowed into fixed-rate conduit fusion deals, Pendergast says, and since Sept. 11, 2001, in particular, it has been "very difficult to do stand-alone asset deals, because no one wants to take that risk." Even though the percentage of hotel loans in conduit formats hasn't increased dramatically, it hasn't dropped much lower either since Sept. 11, Pendergast says.

"This [hotel] sector has done better and should do better because the economy and demand is picking up, [and] travelers are becoming more accustomed to a post-9/11 environment," Pendergast says. "But if we have another terrorist attack we'll be right back where we started from. It's good that there was very little if any development in the hotel market after 9/11, so there isn't a huge glut of supply.

"The market is ready to see a slight incremental increase of hotel exposure in these transactions, because deals with hotel-only collateral have increasingly done better and better in terms of the pricing and reception in the marketplace," Pendergast says.

In a late June report she authored for her company, Pendergast noted that hotel underwriting criteria for fixed-rate commercial mortgage loans in a post-9/11 environment have generally held steady or become slightly more conservative. For example, they have amortization schedules that are shortened to 20 years and 25 years from 30 years, and few fixed-rate hotel loans with interest-only periods.

"Stand-alone, limited-service and non-flagged hotels are generally frowned upon, although they are done on an exception basis. Larger, destination hotels with stable operating histories are the preferred segment," Pendergast says. "While not necessarily a post-Sept. 11, 2001, issue, investors and lenders alike have displayed an aversion to older, exterior-entry properties, no matter how well they are operating or how well-maintained; there is fear that the franchise agreements will not be renewed for these properties.

"The main challenge for the hotel industry in 2004 is to improve room rates, without overly sacrificing occupancies. To the good, hotel supply growth remained quite stable in 2003, rising by just 1.3 percent. In contrast, demand rose by 1.6 percent; this was the first time this occurred since 2001. Most expectations are for RevPARs to increase by around 3 percent in 2004 versus just 0.2 percent in 2003. Hotel operators stand poised to benefit not only from increased demand, but also from the improved efficiency of their operations and the increased use of the Internet and online reservation channels," Pendergast says.

"An improving hotel sector suggests that increased hotel loans will find their way to the CMBS marketplace," says Pendergast. "Toward that end, we expect to see an increasing percentage of hotel loans included in conduit/fusion fixed-rate deals, as well as an increasing number of single-asset/borrower hotel securitizations. Given the heightened caution exercised when reviewing these loans on the part of originators, rating agencies and B-piece investors, we would argue that hotel CMBS loans in the post-Sept. 11, 2001, environment are a net positive to the sector."

RELATED ARTICLE: Good Quarters, Great Dollars

A SAMPLING OF FINANCIAL RESULTS REPORTED BY publicly traded U.S. hotel enterprises for the first and second quarters of this year, ending June 30, confirms a revival driven by surging business and leisure travel.

Host Marriott Corporation, Bethesda, Maryland, the largest U.S. lodging real estate investment trust (REIT), reported revenue per available room (RevPAR) for the second quarter increased 8.8 percent compared with the same period in 2003, with a 5.3 percent increase in occupancy and 1.1 percent increase in average room rates.

Hilton Hotels Corporation, Los Angeles, reported earnings increased 39 percent in the second quarter. Net income rose to $75 million over $54 million in the same period last year. RevPAR was up by 8.3 percent for the second quarter, compared with a 2.9 percent increase in the first quarter.

Fairmont Hotels & Resorts Inc., a Toronto-based international chain, reported operating revenues increased 20.6 percent, also RevPAR by 22.7 percent, occupancy by 19.8 percent and the average daily rate (ADR) by 2.5 percent during the second quarter of this year for its own properties (not the ones it manages), compared with the same period last year.

LaSalle Hotel Properties, Bethesda, Maryland, reported RevPAR for the second quarter was 15.9 percent higher, the average daily rate (ADR) of $155.05 was 6.4 percent higher and occupancy increased by 8.9 percent to 73.4 percent over the same quarter last year.

Albert Warson is a Toronto-based writer specializing in real estate-related subjects. He can be reached at [e-mail].