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Hotels blown away by weak demand. (Commercial).

San Francisco wins the dubious award for weakest hotel market, according to industry research. But the SF market displays many of the same negative trends hurting other markets. We examine a mix of positive (Philadelphia) to rebounding (Nashville) to weak (SF) markets to see why Moody's gave the hotel sector a composite national score of zero in a third-quarter 2002 report.

THE NATION'S LODGING INDUSTRY, COPING WITH A PANDORA'S BOX OF PROBLEMS, is making strides toward recovery--but is not expected to experience a significant rebound until 2004.

Not surprisingly, one of the major problems is a continued falloff in business travel as companies cut travel expenditures in a soft economy. Reflecting that, in September 2002 the National Business Travel Association (NBTA), Alexandria, Virginia, surveyed 2000 corporate travel managers. Seventy percent of those surveyed said their travel expenditures dropped as much as 20 percent in 2002 compared with 2001.

But that's only one of a whole litany of woes affecting the industry. Accounting giant PricewaterhouseCoopers LLP (PwC), New York, which tracks the industry, cites a number of other problems in its revised lodging forecast published in August 2002.

The problems include the impact of the lackluster economy, the negative wealth effect from sharp declines in stock values, erosion in consumer confidence, increasing frustration with the inconvenience of air travel and heightened fears of U.S. action Lodging industry problems in many respects mirror the economy in general, which is experiencing a rocky recovery.

against Iraq. According to PwC's August forecast, the combination of these factors "will restrain lodging demand growth and encourage continued [rate] discounting through the end of 2002.

As a result, PwC expected RevPARs (revenues per available room) to decline 2.3 percent for calendar year 2002. And lacking a catalyst for a strong rebound in business travel, a RevPAR hike of 3.5 percent is forecast for 2003, according to PwC. A more robust outlook is delayed until 2004. when RevPARs are expected to improve by 5.6 percent, according to PwC. Occupancies in 2003 are expected to improve a mere 0.6 percent from 2002, PwC forecasts.

Target recovery for 2004

"We do not anticipate a robust recovery of the sector until the first quarter of 2004, and factoring out inflation, even then RevPAR will only be equal to 1996 levels," says Bjorn Hanson, global industry leader of PwC's Hospitality and Leisure Practice.

Smith Travel Research (STR), Hendersonville, Tennessee, projects a 3 percent RevPAR increase in 2003 from a 1.7 percent deficit in 2002, coupled with a i percent increase in occupancies in 2003 compared with 2002.

Lodging industry problems in many respects mirror the economy in general, which is experiencing a rocky recovery. Reflecting that, Chicago-based Real Estate Research Corporation (RERC) expects no recovery until mid-2003 at the earliest, and estimates (with 75 percent probability) that the rebound will be flat to modest.

New York--based Jones Lang LaSalle Hotels, a division of Chicago-based Jones Lang LaSalle, looks for a cross between a U-shaped and a V-shaped recovery, with modest gross domestic product (GDP) growth of 3.1 percent in 2003. Jones Lang LaSalle concedes that the lodging industry is digging out of one of the sharpest downturns in history, but notes the industry is much better positioned to absorb the downturn now than it was during the 1992 recession.

That's because hotel profitability at the operating level has been protected to an extent by solid reserves and a continual improvement in operating ratios, according to Jones Lang LaSalle.

Moody's report

One of the major barometers of the hotel market is New York--based Moody's Investors Service's quarterly CMBS: Red-Yellow-Green"' Update. The report reviews the health of the underlying real estate supporting commercial mortgage-backed securities (CMBS). It ranks property types and markets in terms of green (not under stress), yellow (on the cusp of imbalance and therefore fragile) and red (already under imminent stress from supply-demand imbalances). In addition, Moody's adds a numerical scoring system to make the color scheme rankings more exact, using a scale of zero to 100.

In its third-quarter 2002 Red-Yellow-Green Update, Moody's singles out the hotel industry for a composite national score of zero, putting it at the bottom of the barrel for commercial property segments. Among the 25 hotel markets it covers, Moody's says only two are green, none is yellow and 23 are red-21 of which have scores of zero, matching the national average score.

The two green markets are Philadelphia (score of 74) and Norfolk, Virginia (score of 100--demand outpaces supply primarily because of the military presence). Philadelphia is profiled later in this article, as are Nashville, Tennessee (a market pegged as making a small but encouraging comeback), and San Francisco, regarded as the nation's worst hotel market.

Sally Gordon, vice president and senior credit officer of Moody's, doesn't expect recovery to start until spring or summer of 2003 at the earliest. She explains that hotel occupancies tend to correlate with GDP growth, and with current economic uncertainties it's more difficult than usual to forecast improvement.

"Demand for hotel space is uncertain, and that demand is required first for recovery. Economic growth will fuel demand," says Gordon.

She adds the reason for so many red markets is the hotel industry has been under stress for two years. "It was weakening before 9/11, and since then has dropped like a stone," she says.

Even a year and a half later, there's still a hangover from Sept. 11 affecting both business and leisure travel, according to Orlando, Florida--based Yesawich, Pepperdine, Brown & Russell (YPB&R), a marketing services firm specializing in the travel industry.

Two surveys taken early in 2002 by the organization represent views prevailing through the remainder of last year. These surveys indicated that nearly 18 percent of business and leisure travelers said their future travel plans continue to be affected by the terrorist events of Sept. 11. YPB&R says the polls were conducted with 800 qualified U.S. adult travelers during the week of Jan. 14, 2002. YPB&R describes business travel demand as remaining "in the doldrums."

A positive note

In the midst of all this gloom, however, there are some rays of sunshine.

Kirby Payne, chairman of the Washington, D.C.--based American Hotel & Lodging Association (AH&LA), says, "We're still making money," although he concedes that the industry--optimistic by nature--has been overeager in anticipating recovery.

Another positive statement comes from PwC, which predicted in a second-quarter 2002 report that the lodging industry would post aggregate profits of $16.7 billion in 2002 (up from $16.2 billion in 2001) as a result of cost reductions initiated in 2001. Revenues were projected to increase to $109.7 billion in 2002 from $108.7 billion in the previous year.

Payne says lodging operators were well-prepared to implement recovery measures in 2002, focusing on operating efficiencies and marketing opportunities--the latter mainly in the drive-to market.

Other industry experts confirm operators are employing a number of strategies to help pull themselves out of the recession.

For example, Ted Mandigo, president of T.R. Mandigo & Company, Elmhurst, Illinois, hotel consultants, cites widespread room-rate discounting, promotional packaging and use of the Internet to advertise rates and generate more business.

"There's real pressure on room rates," he says. "Smaller operators are looking at any occupancy as a benefit."

Mandigo says successful cost controls have included tightening productivity standards, using supervisory personnel to cover peak periods, scheduling work hours more flexibly for full-time positions, putting renovations on hold and providing lower-cost food service such as buffets for group meetings.

Dan Lesser, managing director--hospitality industry for Cushman & Wakefield, New York, says there's been a reorientation of marketing dollars designed to "put heads in the beds," That includes focusing on drive-in patronage within a 250- to 300-mile radius, trying to obtain tax reductions and installation of energy-saving devices such as those that turn off power when the room is vacated. He also notes a variety of package deals designed to attract customers.

Steven Marx, president of Chicago-based Hotel Source Inc., a hotel brokerage firm, lists cost-cutting measures such as reducing hours of room service, cutting sales positions and closing some food and beverage operations, which he says are usually loss items in hotels.

Sources interviewed agree there won't be any meaningful recovery until the U.S. economy gets going again, coupled with strong employment growth. Most foresee, as noted earlier, gradual recovery starting in late 2003 and extending into 2004.

As for the surviving hotels in a down economy, sources interviewed cite units located in drive-to locations, economy-type hotels offering cheaper rates, limited-service properties offering rooms only and, in some cases, older hotels that are supported by a lot of equity. Experts also note that many less-expensive units are benefiting from reductions in corporate travel budgets.

The lender's perspective

On the financial front, lenders are not pulling back on hotels, says Payne. "Lenders have money and want to get it out. The problem is more on the investment side, with investors skeptical about when the market will come back. This not a good time for new hotel construction, but viable deals will get done," he says.

Marx agrees there's lender interest in financing hotel deals, but they're being very cautious. "Sound deals are getting done, and equity is starting to come back from people staying out of the stock market," he says. "They're looking at real estate in general as a good place to put their money now.

That's confirmed by Jones Lang LaSalle Hotels in its second-quarter 2002 Investor Sentiment Survey, a biannual report that indicates investors have become more upbeat on many of the U.S. hotel markets. Trading expectations over the short term are still weighted toward the negative, but a significantly higher proportion of investors believe the market will be flat or improve, according to the report.

Moody's Gordon, however, takes a decidedly less optimistic view. She says lenders and investors have retreated from the hotel market. "Lenders and investors perceive hotels to be operating businesses, not real estate. Commercial real estate is strictly keyed to tenants and does not reprice as quickly as hotels, which reprice on a daily basis," she says.

"Hotels as operating businesses present many different levels of risk, not just tenants. They also represent a higher level of risk--and the wrong kind of risk for many lenders and investors," Gordon says.

Buyer-seller disconnect

Marx, Mandigo and Lesser agree there's a disconnect between buyers and sellers of hotel properties currently. Marx expects the gap to narrow in 2003, with an increase in sales activity

Mandigo notes buyers were expecting to get bargain prices but that hasn't materialized. Lesser agrees investors expected a wave of bankruptcies in the wake of Sept. 11. "It hasn't happened because hotels are much better structured financially today. On a loan-to-value [LTV] basis, there's less debt than there was 10 years ago. In addition, [the] interest rate on that debt is lower than it was 10 years earlier, so the end result has been stronger bottom lines," Lesser says.

Jones Lang LaSalle Hotels adds that the "fire sales" experienced during the 1992 recession haven't materialized this time around on the capital markets level.

Conservative lending and a more-educated investment market lowered the mortgage default rate to a historically low 0.39 percent in the third quarter of 2002, according to Jones Lang LaSalle, quoting the Washington, D.C.-based American Council of Life Insurers (ACLI) as its source.

What's the single biggest hurdle facing hoteliers as they enter the new year? Mandigo sums it up by saying operators have used up all their short-term options for recovery. "All the easy solutions are gone now, so operators will have to be creative and aggressive in meeting long-term requirements," he says. Now let's look at some specific markets.

PHILADELPHIA

Philadelphia's lodging market turned in a positive performance in 2002, contrary to the vast majority of the nation's hotel markets.

As one of only two green hotel markets in the Moody's Investors Service third-quarter 2002 Red-Yellow-Green Update, it's the only market besides Norfolk with a positive increase in revPAR (+1.4 percent). Demand exceeds supply by 1.7 percent in Philadelphia. As a result, Moody's assigns a numerical score of 74 to Philly, up 4 points from the previous quarter.

Favorable stats on this market are also reported by Smith Travel Research. The research company indicates both occupancies and revPARs were up for the first nine months of 2002 compared with 2001, the former by 2.7 percent and the latter by 2.9 percent.

Industry experts say group and convention-related demand fuels the Philadelphia hotel market and accounts for its favorable 2002 results. However, the 2003 outlook isn't so rosy because prospects for that demand is weakening, according to Clarke Blynn, president of Gulph Creek Hotels, Wayne, Pennsylvania, and a former hotel industry consultant.

Blynn points out that convention business is expected to be down considerably in 2003, from a total of 27 conventions to be held in the city's convention center to 14. Union disputes over work rules involving the city's convention center have clouded the picture, according to the Philadelphia office of San Francisco--based PKF Consulting, a hospitality industry consultant. PKF agrees that some problems have arisen with union labor rules, which essentially translate into higher costs to the user. This issue must be addressed by the civic leadership in order to compete effectively for the large national conventions, according to PKF.

Blynn and others characterize the Philly hotel market as stable but soft. It's been difficult to absorb the supply increases over the last three to four years, says Peter Tyson, managing director of Horwath Horizon Hospitality Advisors, Philadelphia.

Jerry Earnest, managing director and senior vice president of Horsham, Pennsylvania--based GMAC Commercial Mortgage (GMACCM), notes the Philadelphia metropolitan statistical area (MSA) hotel market held up well in 2002 despite some overbuilding in the two previous years. "We've been relatively stable for the past 12 months compared with other Northeastern markets, because we didn't experience an oversupply of rooms to the degree that many of them did," he notes.

Philadelphia operators are implementing a number of creative promotional programs to build business, industry sources say. Blynn cites "Sleep Over in Philly" as one of the best.

Blynn says the Philadelphia Hotel Association spent more than $2 million on the campaign, which promoted leisure travel by reaching out to major feeder markets such as New York, New Jersey, Connecticut and the Washington D.C.--Baltimore area. During the six-month run of the campaign in 2001 and 2002, more than 50,000 room nights were booked. "It was one of the most successful hotel promotions in the nation," Blynn says. Tyson says the promotion will be repeated.

The Greater Philadelphia Tourism and Marketing Corporation is also promoting weekend travel with rate discounts and package deals. Group and regional travel promotions are designed to take up the slack from downtown business travel, reducing rates in Center City and some submarkets, according to Earnest. Marketing to smaller short-lead-time group meetings also has been somewhat successful, says Tyson. One magnet expected to help draw travelers is a new visitors' center, which opened in 2002 and features historical attractions, he adds.

There's agreement that the outlook for the 2003 hotel market is not that favorable. "It's going to be rough," says Blynn. "There'll be smaller meetings, but they won't compensate for the lack of citywide conventions." Tyson also cites the convention downturn.

Earnest sees no material recovery, because business travel has not picked up and there's been no major increase in group business. "Leisure travel is expected to weaken or stay the same," he says.

Lenders cut back

Lenders are retrenching on hotels for a number of reasons. Blynn says there aren't many prospects for growth, hotels are under pressure financially and lenders are nervous about a potential war with Iraq and the economic and political repercussions.

Earnest says hotels are a more difficult product to Finance, but adds that quality units with strong sponsorship and in-place cash flows will have no difficulty obtaining financing.

Tyson notes that lenders are concerned about additions to supply, the national economy and the downturn in travel. "Hotels appeal to only a small sector of lenders, but [they] are more nervous than usual," he says.

On the investment side, Earnest says equity is harder to obtain but vulture capital is available to purchase quality hotels at distressed rates. "However, very few have been traded at those rates," he says.

Blynn and Tyson cite a major disconnect between buyers and sellers over prices. "Investors have capital, but there's little product to invest in and what is available tends to be over-priced," Tyson notes. Blynn observes activity in the budget-hotel sector, but not a lot above the 80- to 100-room level.

Limited-service hotels have fared the best in a soft economy, say Earnest and Blynn. These units, without food and beverage, can offer rooms equal to full-service hotels at lower prices. Tyson nominates as the foremost survivors the more upscale and larger properties because most are located in Center City Philadelphia, which he says enjoyed a good convention year in 2002.

NASHVILLE

Nashville's hotel market is faring better than the hotel sector nationwide, but it still hasn't climbed fully out of the recession.

While Nashville is still solidly in the red, according to Moody's third-quarter 2002 Red-Yellow-Green Update, "Hints of recovery are visible," the report states. Nashville is assigned a numerical score of 26, one of only two cities (the other is St. Louis) to obtain a red-zone score of better than zero.

Smith Travel Research reports a 0.2 percent decline in occupancies for the first nine months of 2002 versus 2001, coupled with a 2 percent drop in revPARs.

R. Barry Cullen, senior vice president of Laureate Capital LLC, Nashville, mortgage bankers, a wholly owned subsidiary of BB&T Bank, Winston-Salem, North Carolina, describes the market as soft in the wake of the closing of Opryland Theme Park. However, he says, "The patient is sick but improving."

Not aggressive enough

Rick Stanfield, president of Nashville-based Stanfield Hospitality Consultants LLC, says there's been a dropoff in business and convention travel. In Stanfield's view, operators are not being aggressive enough about cost-cutting measures. "They haven't been willing to make investments to improve service and cut costs at the same time," he says.

Drew Dimond, president of Dimond Hospitality Consulting Group, Nashville, and president of the Alexandria, Virginia-based International Society of Hospitality Consultants (ISHC), disagrees on the issue of a slowdown in business travel to Nashville. "Leisure travel has dropped off, but business travel is remaining steady and not declining like the rest of the country," he says.

Hoteliers are working closely with public and private agencies to boost business travel. Stanfield says more effort is being directed to getting conventions and marketing Nashville as a tourist destination. Hoteliers are putting together more promotional packages as well. But interestingly, Stanfield says, room rates are starting to rise after being cut in the first quarter of 2002.

Dimond views the market differently, saying room rates are being discounted. "The public is expecting lower rates, so operators are following suit with their competition," he says. "That's a mistake. They should be stressing quality rather than following discounts. They can't cut too much more."

Opinions vary on the outlook for the Nashville lodging market in 2003. Stanfield and Dimond look for a flat market. Cullen, however, says he's optimistic because of Nashville's economic stability and low unemployment. "We're getting new businesses coming in here," he adds. Stanfield expects occupancies to improve in 2004 as demand creeps back up.

Stanfield says lenders have retreated from hotels because of the risk involved. "There's very little activity. They want more equity up front from the developer," he notes. Cullen agrees, and says underwriting is tight with 65 percent LTV and shorter amortization required.

"Anyone trying to refinance and pull equity out is in for a tough road," he observes.

Dimond, though, says lenders are being more selective but not deserting the market. "They lend to current customers who have proven they know how to operate hotels, but are turning new borrowers down flat," he says.

On the investment front, Stanfield and Cullen cite a lack of investor interest in hotels. Stanfield says it's hard to show investors the returns they want with the declines in the travel industry.

Cullen says he hasn't seen a hotel sale in two years. "Hotels are very management-intensive, and that's a drawback for many investors," he explains. "You need a track record, because management is the cornerstone of hotel success."

Investor interest

Dimond says investors are attracted to hotels versus the stock market because they provide an income stream. "In many cases, the investor gets paid first out of the cash flow," he notes. Dimond adds buyers have been expecting huge drops in the asking prices for hotels--but that hasn't happened.

The types of hotels most resistant to the downturn have been the major national flags, due to expanded national reservation systems, high-profile management and good locations, says Cullen.

Stanfield's choice for hotel type that has held up well is limited-service properties, because larger numbers of people are driving and these units are less expensive. In Dimond's view, extended-stay hotels have fared better than others because they are insulated from the dropoff in weekend business.

Stanfield concludes, "Nashville is in a far better position than many other hotel markets because we're keyed to the convention business for associations, which is recession-proof versus the corporate convention business. Our association bookings go 10 years out."

SAN FRANCISCO

San Francisco has the dubious distinction of being the nation's worst hotel market, according to some leading industry experts.

"Baghdad by the Bay" draws a score of zero from Moody's in its third-quarter 2002 Red-Yellow-Green Update. While San Francisco has plenty of company in that regard, Moody's says the city has the largest supply-demand gap in the hotel sector (-14.9 percent) and the biggest plunge in revPARs (-27.5 percent) versus second-quarter 2002.

The story doesn't get any better if you consult Smith Travel Research surveys. STR cites a 10.2 percent decline in occupancies for the first nine months of 2002 versus 2001, and a 23.5 percent drop in revPARs.

Three basic drivers erode

There are many reasons for the dramatic downturn but most have to do with erosion of the three basic hotel space drivers in this market, says Rick Swig, president of RSBA & Associates, San Francisco, a hotel consultant. "Leisure, commercial and group travel all fell apart--leisure because of the terrorist issue and the economy; commercial because of the high-tech meltdown; and group because of the economy," he says.

Suzanne Mellen, managing director in the San Francisco office of Long Island, New York-based HVS International, a hotel consultant, points to a major decline in fly-in traffic (normally 85 percent of San Francisco traffic is fly-in) coupled with the high-tech meltdown and a very weak convention calendar for 2002.

"Unlike many cities where commercial demand is expected to recover when the U.S. economy turns around, in San Francisco most of the high-spending dot-com demand is now permanently gone and more-traditional sources of business will have to establish themselves before we experience a return to the robust business of the mid- to late-1990," Mellen says.

Scott Monasch, director of Barry S. Slatt Mortgage Company, San Francisco, mortgage bankers, says the hotel market peaked in 2000 and started to deteriorate prior to Sept. 11. "We were at such high numbers that keeping it up was unrealistic," he says.

Arthur Buser, managing director of the Western Region for Jones Lang LaSalle Hotels, Los Angeles, says the market has hit bottom--but he offers some ray of hope. "The worst is over," he maintains. "The falloff in international travel is expected to rebound, corporate travel budgets are not being cut anymore and convention group business is starting to come back."

Lodging operators are employing a number of strategies to pull themselves out of the slump. Buser lists more focus on regional travel highlighting San Francisco as a destination by auto. Hotels also are offering package deals and discounting room rates. "Some are offering 25 percent to 40 percent lower rates than 2000, as customers shop for the best value," he notes.

Monasch sees more package deals and marketing to the group/convention business. Swig agrees, saying operators are cutting rates significantly and putting more emphasis on soliciting small-group business.

Expect more convention business

Opinion is divided as to the lodging market outlook for 2003. Monasch expects the market to be flat, with occupancy rates ranging from 63 percent to 65 percent. "But there's a lot of optimism for 2004," he adds.

Buser foresees a slightly increased level of activity in 2003. While business travel is flat, convention business should increase with the $191-million expansion of the Moscone Convention Center, he says. Swig concurs with the improving outlook keyed to the opening of Moscone Convention Center West. "It's already booked into 2012," he notes.

Mellen sides with the others in forecasting an improved convention calendar, but says a lot of recovery depends on the national economy. "We also need international travelers back, but don't see that happening with the specter of war with Iraq," she says.

Sources say lenders are not deserting the hotel market, but are being very conservative with tight underwriting standards, more equity requirements and lower LTV ratios.

Buser points out that loan amounts are less because cash flows are down. Monasch says lenders are being more selective, analyzing micro market trends versus macro market trends. Swig explains that there've been very few hotel deals in the last year and a half because lenders consider hotels risky.

On the investment side, as in other markets, there are many willing buyers but a sizable disconnect between buyers and sellers over price. Swig says lending and investment will pick up "when transactions start to flow again," and expects that to happen when interest rates start to rise. Mellen says it's happening already, because San Francisco's economy is becoming more stabilized. "We see a big rebound coming out of the recession, but it's not here yet," she says.

From this look at three different markets, it's apparent the U.S. hotel industry is faced with major obstacles and is surrounded by economic uncertainties. Even so, there are some positive developments and indications of progress going into 2003. Continued profitability and historically low default rates are harbingers of better times ahead.

John Bell is a Chicago-based freelance writer specializing in commercial real estate and finance.
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Date:Jan 1, 2003
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