Waiting for a Wake-Up Call

Hospitality Looks for Signs of Recovery as the Economy Remains Uncertain.

The ongoing economic sluggishness, compounded by military action abroad, continues to take its toll on the hospitality industry. Luxury and first-class properties in destinations that rely on commercial travelers, air arrivals, and international visitors face room rate integrity issues, while hotels in second-tier commercial and drive-to markets are faring better. Leisure demand is weak in many markets, particularly those dependent on air travel. Destination resorts must cope with shorter leisure-demand booking times and travelers who prefer options closer to home. Hoteliers in the economy and midscale segments struggle as consumers increasingly use online tools to comparison shop and move away from brand loyalty.

Recovery Ahead?

Despite these concerns, improved industry fundamentals, particularly a sharply reduced development pipeline, shed encouraging light on the industry's near-term outlook. Overall, the decreased supply should help maintain stable occupancy levels and spur revenue per available room recovery by late 2003 or early 2004.

Although a moderated pipeline has assisted current hospitality owners, a new development cycle may be on the horizon. With stronger recovery expected by 2004, now may be the right time to contemplate new development projects. For example, mixed-use developments with diversified cash flows from different real estate components and full-service hotels in 24-hour cities are more appealing to investors than limited-service or economy properties, which typically have low barriers to entry and less differentiation among brands. In addition, public investment is an important component of the capital structure and should continue to be in the foreseeable future.

Development Trends

The highly disciplined capital markets that currently slow the supply pipeline may stymie new developments if the hospitality industry experiences a quick revival. To get projects out of the ground, developers need to investigate new trends such as condominium hotels and alternate funding sources such as public entities.

Condominium Hotels. Especially prominent in traditionally seasonal resort areas, condominium hotels are an interesting hybrid between investment and second-home properties and have resurfaced as a creative way to raise capital for hotel development.

Condominium hotel marketing strategies target potential buyers seeking investment units. Typically, the units are smaller than primary-residence condominiums and have standard furniture packages included in the purchase price. The owner purchases the condominium but does not use it as a residence. Rather, the unit is rented as a regular hotel room, and the management company and owner share the revenue, usually a 50-50 split after a small management fee.

Condominium hotel units differ from traditional hotel rooms in both positive and negative respects. On the plus side, the developer generally adds features to enhance the units' appeal to potential buyers. Other advantages include instant financing for the developer generated from condominium hotel unit sales; lower fixed costs for the hotel operator since unit owners pay a portion of real estate taxes and insurance, energy, and maintenance fees; and defrayed costs of second-home ownership for potential buyers due to rent revenues.

Disadvantages of condominium hotels include stringent legal requirements such as Securities and Exchange Commission registration for pooling all units' revenues, divergent development objectives (hotel versus condominium), and owner/operator conflicts such as how to split revenues and expenses. Also, condominium hotels typically allow owners several weeks of room use per year, which presents availability fluctuations for hotel guests.

Public/Private Partnerships.

Today's stringent underwriting criteria, coupled with the general perception that hotels have higher asset-class investment risk than other real estate, present several challenges to meeting private sector investors' required returns. In a risk-averse market, developers need to be more creative in identifying deal structures that can fund their projects.

The public sector has become more involved in revitalizing urban locations, which typically begins with a major hospitality development such as a convention headquarters hotel. These projects can provide the incentives needed to satisfy private sector investors, according to Brian Tress, a senior manager in Ernst & Young's Hospitality Advisory Services. While the private developer receives the capital for its project, the public entity and the local community reap many partnership benefits, such as tax revenues resulting from the project, increased property values in the surrounding area, and new jobs, Tress says.

Furthermore, municipalities favorably view convention headquarters hotels because they enhance cities' competitive positions as convention destinations. Event organizers typically prioritize the availability of a headquarters hotel that is adjacent to the convention center when selecting an event location. The most successful convention destinations are those cities that offer pedestrian-friendly areas with imaginative lodging, shops, and restaurants combined with public spaces and cultural and sporting facilities.

The Big Picture

Although thwarted by the economy, decreased travel, and a lack of capital for new development, the hospitality community is by no means a passive player. Hotel operators are positioning their properties to withstand what remains of the waiting game by instituting cost-cutting measures, contracting the supply pipeline, and focusing on value drivers such as distinctive amenities and special accommodation packages to combat rate erosion and reinforce brand positioning. Hoteliers that have failed to embrace such proactive strategies are more likely to face further performance and profitability declines.

Occupancy. The industry managed to keep occupancy levels buoyant in 2002: Year-end rates closed only 0.3 percent less than 2001, according to Ernst & Young's 2003 National Lodging Forecast. During the remainder of 2003, occupancy rates should improve further, with a 0.5 percent increase over last year estimated.

Although new development is under control, certain markets anticipate significant new inventory this year, as projects funded during the late 1990s and 2000 near completion. New room completions in 2003 should decrease by nearly 35 percent compared to 2002, assisting the industry's return to improved occupancy levels.

Drive-to destinations exhibit stronger occupancy levels than gateway cities that are more dependent on air arrivals. Higher-rated business travel remains sluggish, as corporations continue to limit capital expenditures on new investments and initiatives, tap into technology-assisted meeting alternatives, send fewer associates on business trips, and negotiate more aggressively with hotels.

Average Daily Rate. ADRs in 2002 declined 2 percent from 2001. Although individual markets diverge widely, this year's estimated ADR is anticipated to increase 2.3 percent over last year. Trends such as significant rate discounting, frequent-guest promotions, and online discount hotel reservation engines point to the possibility of ongoing rate erosion brought on by the commoditization of hotel rooms, particularly in the economy and midscale segments. However, upscale, first-class, luxury, and resort properties, where consumers place a higher value on personalized service and attention to detail, appear less affected by these risks.

Hotel operators now must face the challenge of utilizing technology as an effective distribution channel while also creating and retaining brand equity through differentiation. Creating a unique sense of place with services and activities that meet or exceed consumers' desires and lifestyle standards may be one path back to brand loyalty. Operators in economy and midscale segments must continue to take advantage of various distribution channels, while fending off the trend toward commoditization of their inventory.

RevPAR. While 2002 RevPAR declined 2.6 percent relative to 2001, this year the hospitality industry should experience a revPAR increase of approximately 3 percent, moderately exceeding last year's performance.

However, since late 2002 the gap between buyers and sellers appears to be closing, as values have increased despite modest performance improvements. Forward-looking investors perceive that the hospitality industry is poised for a rebound. Not only has the supply pipeline significantly thinned, but hoteliers' efforts to cut operating costs are paying off. As such, though revPAR is not estimated to gain significant ground this year, break-even occupancies have declined, allowing the industry to remain profitable. Thanks to hoteliers' swift actions to control operating costs, profitability is anticipated to increase approximately 4.5 percent in 2003 to $17.6 billion. To keep this momentum, high-profile lodging operators in gateway cities must continue to find ways to contain the rising insurance and increased security requirements costs. These built-in efficiencies should help fuel the industry later this year and in early 2004, when corporate and leisure travel is expected to increase.

The hospitality industry is not anticipated to rebound until the second half of the year. While upcoming economic, political, and social challenges are unpredictable, the lodging industry's operators, developers, lenders, and investors can continue their proactive course by reining in operating costs, closely assessing markets for improving fundamentals, disposing of poor-performing assets, and reinvigorating their marketing efforts to reinforce brand equity.

Mark A. Lunt

Mark A. Lunt is senior manager of the Hospitality Advisory Services practice at Ernst & Young in Miami. Contact him at (305) 358-4111 or Paul R. Arnold, senior consultant of the Hospitality Advisory Services practice at Ernst & Young, collaborated on this article.


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