Fears for hotel over development.
Friday, 16th March 2007
Source : PKF Consulting
Sound industry fundamentals continued to drive US hotel transaction market activity in 2006, not only did the one-off and portfolio sales continue to occur thanks to an avalanche of money from private equity funds, some well-known public companies, such as Four Seasons and LaQuinta changed jerseys in response to "can't refuse" offers from previously unfamiliar names in the hotel industry.

These observations come from an analysis of data collected in connection with the recently released 2007 edition of Hospitality Investment Survey published by PKF Hospitality Research (PKF-HR), an affiliate of PKF Consulting.

"The lingering question on investors' minds is how to maximize yield in a capital-induced frenzy that continues in the face of lowered revenue growth expectations, increasing upward pressure on operating costs, and questionable exit expectations further out on the investment horizon," said Scott Smith MAI, vice president in the Atlanta office of PKF Consulting. "Historically, market expansions abruptly concluded with recession and either war, catastrophic event, or both. With no clear signs of a recession brewing and considering the unpredictability of catastrophic events, the most likely reason why hotel ADRs and asset prices will come down is supply expansion."

Survey Results

The 2007 edition of Hospitality Investment Survey reflects the cautious optimism of both debt and equity capital providers. With overall capitalization rates and discount rates near historic lows for this survey (which began in 1988), property value increases may be moderating. Yet, cash flow growth keeps investors optimistic.

Especially noteworthy among the survey results is the almost two-year increase in the investment holding period. This increase indicates an inclination to view hotels as longer-term "dividend plays" and not so much as short-term opportunistic investments.

Capitalization rates have received a great deal of attention during this cycle, with prices at or near all-time highs. In 2005, the average capitalization rate for all hotels reached an all-time low of 8.88 percent. In the 2006 survey, that number edged up 25 basis points to 9.13 percent, indicating that prices are beginning to moderate. Investment grade assets continue to be the most highly sought after with cap rates ranging from 6 to 8 percent in 2006.

Discount rates, or un-leveraged IRRs, for hotels moved down to 12.96 percent. Consequently, the huge 5.5 percent spread last year between the overall capitalization rate and the discount rate shrunk to 3.83 percent with this survey. The finding suggests that while owner expectations for long-term growth in net operating income have moderated, owners believe the growth rate will continue to exceed the expected rate of inflation.

"Due to the lateness of the cycle, buyers of hotels in 2007 and 2008 should plan on longer holding periods and be willing to give up IRR points due to an absence of meaningful appreciation. The near-term probability of an uptick in capitalization rates is much higher at this juncture than a downtick. The IRR points given up in appreciation can be gained back, plus some, by running successful dividend plays. Logical investment strategies going forward involve development, where feasible and when investors can stomach the risk, and efficiently operating what you acquire to maximize NOI," Smith noted.

Despite fears of rising interest rates and Federal Reserve actions, the cost of financing continues to fall. The interest rate for hotel loans stands at less than 7 percent for the first time since this survey began in 1988. Loan-to-value ratios remained slightly below 70 percent, but are above levels in several prior periods. These mortgage terms indicate that (1) lenders feel adequately protected from a reoccurrence of delinquency and default risk experienced earlier in the 2000s, and (2) any fears today of overly aggressive hotel underwriting standards are unfounded.

A Dividend Play

While a buy and hold investment strategy explicitly means not selling anytime soon, implicitly it means holding on to your money. "Hotel economics 101 tells us that ADR growth dominates RevPAR growth after occupancy has reached a threshold where fewer additional guests will be chewing up expenses and hopefully all guests will pay higher room rates," said John B. (Jack) Corgel Ph.D., Senior Advisor to PKF Hospitality Research and the Robert C. Baker Professor of Real Estate, Cornell University School of Hotel Administration.

However, ADR-driven revenues need to be bolstered by either higher service levels and/or better amenities. During past expansions, money was spent elevating service levels and amenity offerings under the assumption that higher paying guests demand such increases. In addition, some money needs to be spent to remain competitive and conform to franchise requirements. But modest renovation projects divert current cash flow from investor coffers. Some money needs to be spent to remain competitive and conform to franchise requirements. "In this kind of environment, where returns are highly dependent on operating revenues, investors need to carefully evaluate and selectively invest in those projects that promise adequate returns," Corgel concluded.

Fear Of Development

A supplemental article in this year's Hospitality Investment Survey discusses the possibility of unexpected hotel development putting an end to the industry's strong performance measurements. The hotel construction pipeline is full of planned and proposed projects. However, the high cost of construction has kept most of these projects from actually breaking ground.

"If construction costs continue to grow at rates exceeding inflation and property value increases, it is reasonable to assume that existing hotels will be virtual money-printing machines over the next few years. Investors should have great difficulty matching the dividend return on hotels compared to other property types," Corgel observed. "On the other hand, should construction costs decline by 5 to 10 percent, the potential exists for the supply growth to exceed demand growth during the next two years."

"Because of the large number of hotel projects in the proposed and planning stages, and the speed with which projects can move through the pipeline once they become feasible, and due to the presumed sensitivity of supply change to construction cost movements, we recommend that investors closely watch how the prices of land, labor, and materials behave," Corgel advised.

The 2007 Hospitality Investment Survey presents the results from surveys of active hotel owners, equity investors, and debt providers concerning the criteria used for hotel transactions that have, or will occur during the year. The eight-page report contains tables that show the current and historical averages of a dozen critical investment measurements, including capitalization rates and mortgage terms. Data are broken out for 10 different property types.

Copies of the 2007 Hospitality Investment Survey are available for purchase in PKF's online store at www.pkfc.com/store
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