A Hospitable Future
As the travel industry recovers, hotels may provide a comfortable investment option.
Early philosophers believed that ground already covered was the best indicator of what lies ahead. And while the ancient Greeks saw themselves walking backward in time, today’s economic forecasters crunch the numbers from the past decade or two to plot the path ahead. To paraphrase economist John Kenneth Galbraith: Economic forecasts exist to make astrology look respectable.
Yet, as all industry watchers know, commercial real estate is cyclical, and as questions arise about the hotel sector’s recovery, the past terrain should guide us. Over the last three decades, there has been a strong recurring aspect to the U.S. lodging market’s performance.
The early years of each of those decades were challenging for a variety of reasons: property overbuilding, oil price inflation, international military conflicts, and severe financial downturns. But the later years of each of those decades showed stronger performances based on improving hotel market fundamentals of supply and demand, economic growth, and better international relations.
If we look back to see the future, today’s forecast for the U.S. hotel investment climate is sunny and fair, with a number of macroeconomic forces lining up to support the most optimistic outlook in years. (See “Back to the Future” for past hotel profits and a forecast through 2013.)
While investing in U.S. hotel real estate today requires a positive economic outlook and a strong desire to see history repeat itself, several indicators support an upturn. The broader travel industry is showing signs of stabilization and a modest recovery that will be reflected in hotel performance.
Both business and leisure travel are cyclical and driven by job growth and other macroeconomic factors. But the financial success of any hotel venture or investment begins with the local conditions. Lodging markets vary dramatically in market segmentation, local market demand generators, barriers to new supply, local and state political forces, and travel infrastructure such as airports and convention centers. As a result, the real investment questions are answered at the local level. Investors considering a particular market should investigate issues such as barriers to entry for new product in the future, the tourism infrastructure’s health with respect to capacity and condition, union impact, the local commercial and industrial demand profile, and the capacity for international arrivals.
For example, international travel, which represents a sizable dollar value, can dramatically boost visits to U.S. travel entry points and hub cities. But the impact will largely be felt in those markets: Not every U.S. city will have the same direct and indirect benefits. In the same vein, national travel data has varying effects on different markets, so the result is more of a national mosaic than a uniform effect.
From a macro viewpoint, more business and investment-friendly federal, state, and local government policies are likely to result from the fall 2010 elections. Steady U.S. disengagement from Middle East conflicts, and continued success in dampening terrorism also offer hope that international travel will sustain and grow.
Growing evidence from Smith Travel Research and PKF Trends data indicate that revenue per available room — a key measure of hotel profitability — has stabilized across the U.S. Very likely, late 2010 will show some signs of improvement, although for the full year the numbers will only be up slightly or flat. Next year should see significant improvement, and 2012 will be a good year for RevPAR growth. These forecasts are based on some moderate improvement in employment and business activity in general and very little new supply.
In past cycles, the primary dampening effect on the industry was new supply. In part, the lodging market’s cyclical nature is a direct result of “flurries” of new development and product as the market is improving. These increase to the point where they dilute the demand to a level where operations generally produce less income. However, in this cycle, because the current market values of many properties are well below replacement cost, it is unlikely to see any near-term investment in new construction.
The cyclical nature of the lodging business also affects operating costs. During the last two years of decreasing RevPAR, operators and management companies have been pushed to cut costs in any manner possible, hoping to preserve margins and the bottom line while still providing a positive guest experience. Operating expenses for this year have been cut to their lowest levels in an effort to match up with the loss of top-line dollars. The anticipated growth in RevPAR in 2011 and 2012 should produce extraordinary profits based on those recent cost-containment moves.
The impending improvement in both RevPAR and strong profit margins has produced encouraging news in the hotel investment sector. Nearly $1 billion in hotel real estate was sold during first quarter 2010, almost double the volume of the same period in 2009. Last year, the volume of transactions in the U.S. declined to a decade-low of approximately $2 billion, compared with nearly $10 billion recorded during 2008.
Investors are seeing the improved market fundamentals and are getting more aggressive in their pursuits. This trend likely will continue through the rest of this year as investors increasingly take advantage of the market timing.
During the first half of 2010, transaction activity generally has been spread across most property types. (See “Hotel Sales as of July 2010.”) It is interesting to note that nearly two-thirds of the properties sold were in the Southeastern or Western states, and one-third of the properties sold were midscale without food and beverage services. Non-food and beverage properties remain a very popular asset class as this is the element of hotel operations that can hinder real bottom-line performance. The profit in rooms is dramatically better for assets without food and beverage than for assets that provide food and beverage.
High-quality, branded, and well-located hotel assets will increasingly receive the interest of off-shore as well as institutional investors this year. Locations that combine historically strong international travel and appeal, a broad mix of market segments, solid infrastructure, as well as economic and political barriers to entry will be sought by investors. The best locations likely will be in urban centers or strong suburban corporate markets.
In particular, the inflow of Asian-based capital is expected to become more prevalent as these investors, understanding the intrinsic value of hotel and resort assets, seek to acquire at favorable prices relative to replacement cost. Investors from the Asian economies note the cyclical nature of investments in lodging and, based on their generally longer-term view, use replacement cost as a benchmark. Over the longer term, the value of a hotel ultimately will be driven to that benchmark. In today’s investment market, buying below replacement cost can mean that before new competition enters the market, values will have to rise to a premium above replacement costs.
Many investors raised capital to buy distressed hotels including distressed loans, but there have been, up until just recently, very few to buy. The distressed hotel assets are in two classes: banks and commercial mortgage-backed securities servicers. Anecdotally, banks appear to be moving forward on foreclosure proceedings, and in some instances, that product ultimately will make it to market in the form of a note sale or an asset sale. This will be a long process, not a fast cure.
Through these difficult times, brand-related capital projects were postponed or delayed to accommodate the current borrower. With any change of ownership, including a bank foreclosure, the new owner is immediately going to be hit with capital needs to maintain the flag.
The CMBS situation has been slow to resolve based on the complexities of the original issuances in an environment where real property values begin to carve away at the layers of equity. We are hopeful that as incomes begin to grow, values will follow suit and transactions can occur.
Forecasting More Transactions
There are many reasons that the volume of hotel investments will increase over the next several years and values will improve. Using realistic going-in values and planning for the inevitable downturn that may come in four years to six years, investors can profit from the current hotel cycle. Using history as the best indication of where we are going, it appears that marching backwards into the future may be rewarding for hotel investors in 2011 and 2012.
Combining historical and forecasted hotel profits for the period 2001 through 2013 and the transaction volumes for the same period, it is not difficult to anticipate what will happen to transaction volume over the next two to three years. The market aspect that often can burden the future prospects of the lodging industry is new supply growth. When conditions are right, with available financing and new franchises being rolled out, new inventory eventually dampens any recovery. But this concern will be muted as the market is not producing new supply at a level that will have a large negative effect. In comparison to the historical relationship between supply and demand in the U.S., the current forecast for new lodging units for 2010 and 2011 is well below long-term averages. (See “U.S. Lodging Supply/Demand Forecast.”)
The next three years will be an exciting time in hotel investment as the travel and hotel industries begin to recover and show signs of growth. If history repeats itself, we will see a much more vibrant transaction market and many great investment opportunities.