Real Estate Forum - January 2008

Hotel Confidential
By Donald W. Wise
After Several Years of Heated Growth,
Lodging Sector Will Moderate in 2008

TO BORROW A PHRASE FROM WINSTON Churchill, hoteliers need to develop “the seeing eye,” which he defined back in 1937 as “the ability to see beneath the surface of things, to know what is on the other side of the brick wall, to see fairly clearly into a vapory future where others see it only dimly.”

In that vein, it appears that 2007 marked a turning point for the lodging sector. After enjoying several years of significant growth, room rate and occupancy increases in US hotels moderated last year. This slower pace is expected to be sustained over the next couple of years, especially given the recent shifts in the capital markets.

Moreover, PKF Hospitality Research is reaffirming its forecast for a modest slowdown in US lodging industry performance in 2008. For the year, the firm is projecting occupancy levels to experience a slight decline (0.7%), while average daily room rates should grow by 5.3%. The net result is a 4.5% gain in revenue per available room, the slowest movement of RevPAR growth since the recovery from the 2001-03 industry recession. While the PKF forecast calls for a deceleration in revenue increases, it should be noted that the 4.5% RevPAR growth rate is still above the Smith Travel Research long-term average of 3.4%.

Noted economist Dr. Arthur B. Laffer pegs inflation at between 2% and 2.5% for 2008—still a positive arbitrage between RevPAR and inflation. The supply-side economist is best known for the Laffer Curve, a matrix illustrating tax elasticity that asserts in certain situations, a decrease in tax rates could result in an increase in tax revenues.

Speaking of the supply side, the number of new guest rooms being added to the lodging inventory is quite impressive. Lodging Econometrics reports that the new construction pipeline in the US numbered 5,011 projects with 654,503 rooms in the third quarter, representing the fifth consecutive record-setting quarter.

According to Lodging Econometrics, guestroom counts in the pipeline are 31% higher than hospitality’s last peak in 1999. However, the project count is an astonishing 47% greater. Factoring in cancellations and postponements, and new hotel openings of 228 properties with 23,187 rooms, overall activity accelerated by 375 projects with 43,162 rooms quarter-over-quarter.

Surpassing 5,000 projects is a milestone event, Lodging Econometrics states. The firm asserts that it is a reflection of the surge of select-service and mid-mar-ket brands, as well as a number of new, contemporary brands launched in recent years.

What does this mean in terms of the lending environment for hotels? Look for spreads in the 160- to 180-basis point range over the 10-year Treasury on a go-forward basis. But it may take until the first or second quarter of 2008 to reach that level. In the near term, expect spreads in the mid- to even possibly high- 200s until the markets settle down and all the major lenders have taken their write-downs and have closed out their 2007 books.

Eighty-five percent loan-to-cost hotel construction

Equity is what lenders want to see
in deals. And you can forget about
mezzanine debt.

loans are a thing of the past. The “new normal” will be 65% to 75% loan-to-cost levels.

For hotels and resorts, conservative underwriting will be in vogue once again. In particular, the lending community is looking for high-quality sponsorship, a proven ability to execute, more stringent due diligence and disclosure, debt coverage ratios closer to a 1. 4 and fully amortizing debt. Equity is what lenders want to see in deals. And you can forget about mezzanine debt.

So next time you travel to a hotel, stop by the front desk to get your “seeing eye” membership card. It’s better than reward points. ◆

The views expressed in this article are those of the author and not Real Estate Media or its publications.

Donald W. Wise is the global hospitality industry managing partner at Johnson Capital in Napa, CA. He may be contacted at drdon@johnsoncapital.com.