In 1996 the growth in lodging industry fundamentals, such as occupancy and average daily rates, assisted by strong economic indicators continued to be viewed favorably by Wall Street. Ten hotel C-Corps and three REITs entered the public markets in 1996 and along with existing public hotel companies raised more capital than in 1995, which had previously been designated a banner year.

The characteristics of the new kids on the block spoke volumes for the change in those factors considered key to the success of a public hotel company. Bigger appeared to translate to better which was evident in the consolidation trends that characterized 1996. Expansion was rewarded and the premium placed on strong brand or franchise value was more evident than in prior years.

Given the proliferation of public hotel companies in recent years it will become more difficult for newer entrants  unless their size, product. perceived growth potential, and management track record distinguish them from existing public hotel companies. At least two rumored public equity offerings were shelved recently, believed to be due to perceived market indifference to their potential in this hotly competitive marketplace. Global presence will also play a larger role in differentiating the potential public market entrant in 1997.

Consolidation will continue as smaller companies that lack critical mass and face barriers to growth look for merger or alliance possibilities. As technology is widely acknowledged as a key competitive advantage, the tremendous investment required to play in the game will also prompt more merger activity One potential development on the horizon that may affect the desirability of mergers in the future, is the accounting industry's proposal to limit the use of the "pooling of interest" accounting treatment, which has been the method of choice for several recent lodging industry mergers. Under a pooling. in essence the merged companies' balance sheets are combined without restating assets and liabilities to market values. The alternative method, the "purchase accounting method" requires marking the assets and liabilities of the acquired entity to market value, which may result in the establishment of "goodwill" and subsequent higher amortization charges to earnings.

Control of many of the existing public hotel companies is concentrated in the hands of institutional investors attracted by current returns. As the industry heads towards a down cycle as it inevitably will, the priorities of shareholders for short term earnings versus the long term needs of the hospitality business for reinvestment in the physical plant will become an issue. Should the indicators slide, these hotel companies will be forced to deal with pressures to manage their businesses as real estate commodities rather than a seasonal-consumer oriented business.

The better managed and capitalized players with strong brand identity and the lowest cost of capital. however, will be able to weather these challenges and still find opportunities in the secondary capital markets. Those hotel companies that find the public equity market too daunting will be forced to look to alternatives, such as private equity, mortgage backed securities, and structured mezzanine financing. The limitations imposed by the real estate investment trust structure  - relative to distributing a large percentage of their earnings will force smaller, low-growth REITs to consider alternative structures such as conversion to a C-Corp.

In sum. the market is still robust for lodging security offerings, and should remain so for the next 12 months. But analysts are likely to scrutinize more carefully those hotel companies whose earnings performance are not up to expectations, and be tougher on those that don't have a clear strategy for earnings growth and asset appreciation. Wall Street and its view toward lodging stocks -   like the lodging industry in general -   is at a significant crossroad in determining whether to stay in or out of the present lodging business cycle.

The Real Estate Report is published by KPMG's National Real Estate, Hospitality, and Construction Practice. © 1997 by KPMG Peat Marwick LLP All rights reserved. For additional information email KPMG.

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