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Over the last two years we have seen an unprecedented move by lodging companies to tap the public equity markets, A convergence of a strong stock market, the acceptance of REITs as sound investment vehicles and a buoyant lodging market, has resulted in equity capitalization of hotel companies increasing from $12 billion to more than S60 billion since 1991, as numerous REITs and C-corps went public. As the industry environment transforms into one in which assets are generally considered to be fully priced and in which demand growth is likely to dissipate as the economy cools, these companies must focus on maintaining and increasing share-holder value.

Stock analysts generally evaluate pricing in terms of multiple of earnings per share (EPS) or earnings before interest. taxes. depreciation. and amorti-zation (EBITDA). or, in the case of REITs. funds from operations (FF0) or adjusted funds from operations (AFFO). These multiples. however, implicitly take into consideration both future growth potential and risk. Most valuation methodologies involve actually evaluating some measure of future performance by a cost of capital. With out going into various schools of thought on financial theory, it is widely accepted that stock market investors overall expected rate of return is equal to the risk-free rate (rate on long-term treasury bills) plus some market risk premium. Studies have shown that over time. the stock market has earned about 8 percentage points over rates on Treasury notes, or T-bills. Thus. in today's interest rate environment the overall return expectations would be 13 to 14 percent. That expectation would be adjusted for individual companies based on their perceived risk factors. Finally, to the extent a company uses leverage, its cost of capital is lowered by blending the after-tax cost of debt proportionally with the cost (investors' expected return) of equity, giving each company a distinct weighted average cost of capital (WACC). Without going into a complicated analysis, then, it could be fair to assume that the bulk of companies in the lodging universe have an equity cost of capital of somewhere between 12 and 16 percent, implying WACC of  8 to 14 percent, depending on capital structure and tax status (REIT vs. C-corp.).

The issue of a company's cost of capital seems fairly straightforward but is often misunderstood. For example. ana-lysts have recently noted that Crescent Real Estate Equities had a very low cost of capital and thus it was easy to make secretive acquisitions, contributing to FF0 growth. It is certainly easy to make accretive acquisitions when current AFFO yield is 5.2 percent. But then Crescent's stock wasn't bid as high as it is because investors are excited about Richard Rainwater making a lot of 6 percent-yielding deals. Rather the true cost of Crescent equity is not 5.2 percent. In fact, equity investors probably expect somewhere between 12 and 16 percent over the long run, as they would with other stocks. The very reason Crescent's current AFFO yield is less than 6 percent is that investors fully expect that Crescent will be able to make deals that are not only accretive, but massively accretive in the long run.

Starwood Lodging Trust's recent announcement of its intention to buy back stock, although devoid of specifics. is a reflection of its recogni-tion of this reality Trading at an AFFO yield of around 7.4 percent. Starwood could easily find deals that are accretive on a current basis. However. inherent in Starwood's stock price is a true cost of equity capital. Although it is certainly lower than the 90 percent total return Starwood achieved for its shareholders in 1996. it is much higher than the 7.4 percent yield at which it currently trades. Management apparently recognizes that simply accretive growth won't do. The announcement of a buy-back indicates first, that management will show patience in only pursuing opportunities with good long-run return potential. and second, that management considers the stock to be value priced.

Many lodging companies, both C-corps and REITs now find themselves in a challenging position. They tapped the public markets when the capital was available and, in many cases, rode the business cycle to outstanding earnings growth, justifying high multiples in the process. Management may be wise to consider some of the following thoughts in attempting to continue growing shareholder value in this environment:

• Strive to understand the company's true cost of equity. This entails a breakdown of various pieces of the value chain in which the company participates. For example, management and ownership have very different risk and potential growth profiles.
• Analyze the competitive environment in order to identify the areas for investment in which the company has the greatest potential to generate returns exceeding the cost of capital (not just its current earnings yield or AFFO yield).
• Create a capital structure that allows for flexibility while minimizing cost of capital.
• Evaluate all strategic investments against a WACC that is based on the true equity cost. and thus reflects the market's implicit expectations.
• Implement a capital charge in mea-suring performance, so that manage-ment will remain focused on creating value.

The idea of managing for shareholder value is not new. However, it is highly topical in the lodging industry as relatively young public companies must stake out their place in the corporate world  and perform.

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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