Improving lodging industry renews investor interest.

After several years of being passed up by the investment community, the lodging industry has been rediscovered by Wall Street as a hot new area for investment, aiding the industry on its route to recovery.

That's the news from KPMG Peat Marwick's National Real Estate Practice, which recently published a Real Estate Report devoted to the hospitality industry. The report, sent to more than 20,000 real estate professionals nationwide, provides perspectives on current issues and trends facing the lodging industry.

"While most of the real estate industry drags toward recovery, the hospitality sector is moving full speed ahead, with new deals occurring on all fronts," said Francis J. Nardozza, national director of hospitality services for KPMG's Real Estate and Hospitality Practice. "As the activity continues, 1994 will be remembered as the Year of the Deal."

The bright outlook for the hospitality segment, combined with the notion that hotel values have bottomed and are now on the rise, has instigated a surge of purchasing and investment activity that, in all likelihood, will increase as the year unfolds, the practice said.

Over-leveraged and in desperate need of recapitalization, the industry is now being revitalized by the multitude of mergers, acquisitions, securitizations and public offerings propagated by Wall Street, the practice said.

"With the return of liquidity and capital - and Wall Street hungry to do deals in new and creative ways - many more hotel deals are yet to come, and will continue through 1995," Nardozza said.

"One market segment in particular - full-service luxury hotels - has the greatest potential for property appreciation," Nardozza said. "Barriers to market entry are high, financing is practically nonexistent and competition between newly-built luxury hotels and existing properties that have changed hands at bargain prices well below today's construction costs is fierce."

Why the Shift Now?

"A few years ago, a lack of investment capital coupled with the industry's lackluster performance resulted in few transactions with an abundance of hotel owners desperately seeking out the few buyers still active in the market. Now, the good deals are becoming harder and harder to find because competing bidders are starting to drive up prices," Nardozza said.

A combination of factors, including the high yield on equities, the continuing industry recovery and the overwhelming expectation that today's low hotel values will escalate rapidly in the near future, has triggered investor interest, the practice said.

"Because today's equity yields are high in comparison to yields on other types of real estate investments, new investment wisdom reasons that it makes perfect sense to put up large amounts of equity up front to get a hotel deal done - typically up to, 40 to 50 percent of the required investment funding," said Roger L. Johnson, national industry director of the firm's real estate and hospitality practice.

Earlier this year, the practice reported that occupancies and room rates have been steadily increasing over the past two years, indicating that 1994 will likely be the first year in more than a decade that the majority of hotels in the United States will return to operating profitability.

Trends in Acquisitions

"Occupancies and daily average rates steadily have been increasing while management, capital and other expenses have been decreasing or remaining stable," said Jeffrey W. Sachs, a manager in the firm's Atlanta office. "As a result, hotels are operating with greater income, and hotel sales prices are going up."

According to the report, the number of troubled properties has dwindled now that the Resolution Trust Corporation has sold the majority of its repossessed properties. With the supply low, the practice expects prices to begin escalating due to fewer unwilling owners selling properties. In fact, 1993 saw many notable, single hotel acquisitions for as much as $100,000 to $200,000 per room. The report also states that this trend toward larger upscale properties appears to be continuing in 1994 with the recent sales of such renowned properties as the Doral Golf Resort and Saturnia Spa in Miami and The Phoenician in Scottsdale, Arizona.

With hotels becoming a hot new commodity, many new buyers are entering the market, which is dominated by buyers from international hotel chains and independent management companies. Another significant source of buyers has been the owners-operators, who are seeking franchises for their properties.

"Asian and middle-eastern interests have been very active in purchasing limited-service, economy hotels," said Clay B. Dickerson, a senior manager in the firm's Atlanta office. "Interestingly, these individuals are beginning to form investor groups which are, according to brokers, looking for more up-scale, full-service properties."

Acquisition fever has also hit the large real estate funds, such as Morgan Stanley Real Estate Fund, which recently acquired the Red Roof Inn chain for $633 million in a stock purchase.

"With our capital and Red Roof s great management team and brand name, we're looking to grow the chain nationally," said Peter C. Krause, managing director with Morgan Stanley Realty and Chairman of Red Roof Inn. After increasing revenues and profits, and adding a significant number of properties to the chain, we'll consider all the options for exit, including an initial public offering.

Raising Capital

A key player in today's hotel deals, Wall Street is raising large amounts of capital along four major paths, including REITs, mortgage conduits, initial public offerings and high yield note offerings.

Real Estate Investment Trusts (REITs): The popularity of the hotel REIT comes as no surprise given the positive spread between the cost of REIT capital and the yields resulting from investment in undervalued hotel properties, Nardozza said.

After the first and only hotel REIT in 1993, several more small to mid-sized hotel REIT offerings have been completed over the last twelve months by regional underwriters, raising nearly $330 million.

"Elevated by the recovering industry, and now that REIT investors have gotten their feet wet in the hotel market, the next wave of hotel REIT deals will likely tower over those of the past, with large Wall Street investment firms raising more than $150 million each," Johnson said.

Also appealing to investors are the many advantages of REIT structures, including: Corporate tax-free status; Limited liability to investors; Real estate business rather than asset investments; Better access to capital markets; Economies of scale; and investment liquidity.

Mortgage Conduits: "Although less well-known than REITs, these pools of commercial mortgages repackaged into securities, are one of the hottest products in the mortgage-backed securities market today," Nardozza said.

After getting burned by their liberal lending practices in the |80s, banks and other traditional loan sources have been reluctant to make loans. As a result, these mortgage-backed securities are filling the lending void and reallocating scarce capital back into the hospitality market, the practice said.

However, borrowers, who are faced with limited lending sources, will find that mortgage conduit loans are not cheap, with interest rates averaging in the vicinity of ten percent, the practice added.

"Given the strong investor appetite for mortgage-backed securities and the scarcity of borrowing options, these low-risk, high-yield conduits could be here to stay," said Nardozza. "Unless, of course, traditional lenders decide to jump back into the ring, giving the conduits some stiff competition."

Initial Public Offerings: With lodging stocks performing extremely well, trading at multiples of 20 to 30 times their earnings, more and more hotel companies are looking to the stock market to raise funds, the practice said.

Several private hotel companies are planning to go public to take advantage of current favorable market conditions, and lodging companies that are already public have undergone secondary stock offerings for additional capital, such as Host Marriott Corporation.

High Yield Note Offerings: These corporate notes, which are typically sold to qualified institutional buyers and, under certain conditions, can be exempt from registration with the Securities and Exchange Commission, are a common source of funds for hotel companies.

High yield note offerings usually mature in ten years from the date of issue to yield interest at rates ranging from nine to eleven percent, and are frequently used to fund corporate expansions or to refinance maturing bank debt, the practice said.

What's Ahead

While the hospitality industry's future cannot yet be characterized as "rosy," the outlook appears bright, the practice said.

"It's definitely ripe for transaction activity," Krause said. "There's value out there, if targeted acquisitions or investmentS are made carefully. If the homework gets done, the window will be open for the next several years."

"Real estate investment professionals speculate that as the economy gains momentum and as investment demands further outstrip supply, hotel acquisition prices are likely to exceed replacement costs and developers will begin to dust off those old construction blueprints," Johnson said.