The Lodging Market Looks Ahead

New equity could make this sector more hospitable for investors.

Just a short time ago investment in hotels and resorts was relatively straightforward — lodging industry fundamentals were positive and cheap debt was abundant. Lodging, the then-darling of the financial and investment markets, provided a premium return over more mundane investments in industrial facilities, office buildings, and shopping centers. Transactions hit record numbers as existing owners took their profits, and new owners were poised to continue the trend.

This scenario changed last year with the collapse of the commercial mortgage-backed securities market and the resulting standstill in the commercial finance and property markets. Today, hospitality investment is more complex. As market performance flattens, debt becomes more difficult to source and questions arise about the underlying economy and the possibility of a recession. On average, U.S. hotel values are off at least 10 percent, the mortgage market is thin, and transaction volume is far below 2005–07 levels.

“Busted deals” characterize many of the opportunities presented to public and private equity buyers pursuing hotel investments. These deals often involve properties or development projects that need capital and have no financing sources.

When defaults occur on the existing debt and the lender doesn’t want the property back, the stage is set for action. The primary play with busted finance deals is purchasing the note from the lender at a discount. The alternative is to wait for a lender foreclosure or another event that allows the lender to sell the underlying asset to satisfy the lien.

Adapting to a New Reality

Given the current lending environment, these types of opportunities will be a part of the hotel capital and investment markets for the next 12 to 18 months. But there are capital alternatives to a sale or basic debt financing that will accomplish many of the same objectives. Several of the most promising alternatives involve de-leveraging the investment with new equity.

In the hotel sector there is a significant amount of short-term debt, senior and mezzanine, with two to three years remaining. With no change in the hotel lending markets expected over the next six to eight months, many owners must consider de-leveraging with new equity for needed capital. This offers an opportunity for commercial real estate investors interested in entering the hotel market. Given the lack of property investment activity in today’s market, commercial real estate professionals may want to investigate the hospitality market for clients looking for value-add or turnaround opportunities.

More than other types of property investments, hotels are local-demand-oriented. Many U.S. markets continue to operate at very acceptable levels because those markets have strong demand and limited new supply. Today’s hotel investment market brings lower prices, less leverage, higher debt service coverage ratios, and very little pro forma underwriting.

2008 RevPAR Forecast Change, 2Q08

Regional Markets RevPAR Change (%)
50 major U.S. cities 1.3
New England and Mid-Atlantic 3.6
North Central -2.8
South Atlantic 1.4
South Central 1.4
Mountain and Pacific 1.9

Source: PKF Hospitality Research

The hotel investment market will be involved in significant de-leveraging for the next two years. There are two ways to de-leverage: Wait for the market and values to return to previous levels and beyond, or recapitalize with new equity dollars. New equity can come in many forms including renovation work, debt reduction, establishment of financial reserves, or re-branding initiatives.

How De-Leveraging Can Help

Hotel owners are exploring creative ways to structure joint ventures with many types of prospective partners, including passive investors, operators, developers, and hybrid equity/debt or mezzanine lenders. While they can be structured several ways, successful joint ventures generally involve two or more parties who accept the current situation, understand the alternatives, and create a new entity that aligns the parties’ interests in a common plan. Specifically the parties should consider the following points for a successful result:

• align expectations;
• assign specific responsibilities and roles;
• select the most appropriate form of ownership;
• be considerate of existing senior debt covenants;
• rationalize a term of the relationship and consider exit strategies;
• confront control and deadlock resolution issues; and
• provide for allocation of profits and other benefits.

The following examples illustrate two ways de-leveraging through joint-venture partnerships can provide solutions. In both cases, the owners are electing to hold the properties and cannot or will not consider a discounted sale.

In the first example, owners of a California hotel have determined that a renovation and potential rebranding will restore the property’s value. Planning for a $5 million renovation, the owners had to face the current reality that their existing senior debt (CMBS) cannot be replaced or removed economically because of the high cost of defeasance as rates have remained low.

A management company with investment dollars is proposing to create a joint venture that would include a management takeover, infusion of needed renovation funds, and assumption of the existing loan. The current owners get cash to dilute their position, a carried interest/equity in the new venture while giving the new partners control of the operation, and preferred return on all new money.

In a second case, a Washington developer owns a site for a hotel that is working its way through a lengthy public approval process. The land is held in fee and subject to a third-party development loan (11 percent interest only) that has funded most of the costs associated with the entitlement process and an interest reserve. The developer’s plans were to continue the process and refinance the development loan with another lender, including enough funds to complete the approval process and interest carry during that period. However, the owner cannot refinance in this debt climate.

The market appears solid and the project is well-conceived and -planned, but the problem lies in finding the capital to proceed to final approvals and construction.

Another developer has approached and offered to enter a joint-venture development. The new partner is offering to pay down a portion of existing debt and fund all entitlement activities. The new money comes in as preferred equity and receives a preferred return on cash flow and sale or refinance. If all goes well, both parties will combine to make a better development team.

Good Investment Potential

As the stock of existing U.S. hotels continues to age, market dynamics change along with guest profiles. There always will be opportunities to reposition hotels by rebranding, investing, and/or operating from a different perspective. Today’s U.S. boutique hotel market reflects this repositioning opportunity in most major cities, where older properties have been revitalized and repositioned with an entirely different demand base.

The opportunities are constant, but the liquidity in the credit markets provides the glue that holds it all together. Given the prospects for recovery in 2009 and 2010, those with significant equity and a plan can expect great rewards in the next several years. Downside risk is mitigated by owning and investing in barrier-to-entry markets such as Boston, New York, San Francisco, and Seattle. Most urban centers and other destinations that have broad-based market support are benefiting from an influx of foreign visitors, driven in part by currency and buying power as the dollar has slid.

But potential investors must be aware that geographically, there are significant differences in hotel markets. One simple characterization of a market area’s strength is expressed by the relationship of projected revenue per available room, or RevPAR, growth compared to the consumer price index. What is very clear in this comparison is that individual market outlooks have changed in a short time. During 2007, of 50 major markets tracked, 35 were projected to have RevPAR growth above CPI levels in 2008. Only nine markets were expected to fall below CPI levels. As of 2Q08 only 22 markets — less than half — are expected to surpass CPI growth in 2008 and an almost equal number, 21, will fall below CPI pricing increases. This underlines the significance of location in hospitality investments.

This debt-challenged environment has dampened owners’ plans to sell and made buyers less aggressive. Many existing hotels are over-leveraged, but investment opportunities are available in specific markets and with different approaches, such as de-leveraging, that will bring new equity into hospitality ventures.

Robert Eaton

Robert Eaton is executive managing director of Colliers International Hotels in San Francisco. Contact him at


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