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Hotels Starting to Show Signs of Recovery

One property type that is seeing its prospects improve with the economy, after a pronounced downslide in the last few years, is hotel property. The hotel sector has been especially impacted in the recent economic downturn by the drop-off in travel following 9/11, the general impact of the downturn and, just when the effect of that was beginning to wear off, war in Iraq and the SARS scare.

However, hotels are now reporting improved occupancies and revenue. For the third quarter, some major real estate investment trusts, including Bethesda, Md.-based Host Marriott and LaSalle Hotel Properties, have seen their earnings rise.

At the Urban Land Institute's recent fall meeting in New York, Stephen Rushmore, president, HVS International, Mineola, N.Y., noted at a panel session on the lodging industry that the hotel sector, which had seen a significant run-up in value during the period 1992 to 2000, saw values go down after 9/11. However, the drop-off had leveled off in 2003, and he expects a "very strong increase in value" by the end of this year. In the recovery that is taking place, Mr. Rushmore expects that an increase in room rates and financial and operating leverage for hotel properties will lead to an increase in value for the sector.

Risk to the sector is more on the supply side rather than the demand side and he doesn't expect hotel properties to be impacted by oversupply in the near future.

For a typical hotel in the U.S., he is expecting a change in value per room of $55,000 over the period 2003 to 2006, with New York, Oahu and Washington on the top of the list of hotel markets that will gain in value. Cities at the bottom of this list include New Orleans, Chicago, Cincinnati, Detroit and other cities in the "Rust Belt."

A "high watermark" for hotel values was in 2000, Mr. Rushmore said, and he expects the typical hotel to recover to its 2000 value by next year.

In terms of volatility of different hotel markets, based on how likely it is that values will change, for the U.S. as a whole it is 18%. The markets that are least volatile are Sacramento, Calif., and San Antonio at 11% each. Mr. Rushmore recommends investing in hotel markets that have a combination of low volatility and large increases in value.

Hotel markets he considers to be more desirable include Memphis, Miami, Orlando, Seattle, St. Louis, and Washington. And hotel markets he would recommend selling include Detroit, Nashville and New Orleans.

According to him, hotel values are heading up, really good occupancy is on the horizon and he sees an "excellent buying opportunity" right now. He expects room rates to rise at two times the consumer price index rate in most markets, with overbuilding not posing a significant risk in the next three to five years.

Fitch Ratings is also seeing a "steady improvement" in the hotel sector and expects to see more hotel-backed loans being originated for the commercial mortgage-backed securities market. The type of underwriting being done on these properties will be the key to whether these loans will be able to weather future market downturns, according to Fitch.

David Harrison, director, Fitch Ratings, warns, "Hotels do not have the same safety net from short-term market fluctuations that other traditional commercial properties do. Therefore, underwriting credit for improving fundamentals, without acknowledging the hotel sector's inherent volatility could leave investors in CMBS more vulnerable to higher defaults from hotel loans. It is not 2000 anymore and hotel underwriting should reflect that reality." Underwriting based on future value, rather than real cash flow and current operations, which happened in the late 1980s, contributed to the loan defaults of the 1990s, according to Fitch.

An upbeat note for the hotel sector is also seen in the emerging trends in real estate report for 2005 released at the ULI meeting, prepared by the ULI and the accounting firm PricewaterhouseCoopers. The report calls for leisure travel to go up to record levels and business travel to bounce back. Many hotel owners have deferred maintenance on the properties in the "post-9/11 slide," which means that "some revenue gains must be spent on sprucing up rooms and public space."

Good "fly-to" markets - San Francisco, Boston and New York - are seen as the ones offering "the most solid opportunities in full-service categories." The outlook calls for hotel properties to outperform other property sectors, with net operating incomes seeing gains for two or three years before new supply impacts the sector. For commercial real estate overall, the report sees next year as a "race between improving fundamentals and rising interest rates."

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